An Alternative World

I recently attended a conference for investment advisors in Palo Alto.  There were approximately two hundred people in attendance, and we were crammed into a small room that was probably meant for about half the people that attended.  Because we were so cramped, the speaker asked us politely to stay seated until the designated breaks.  This would limit the distraction of people getting out of their seats and awkwardly bumping knees to get through to the aisle.  As hard as it was, we obliged as best as we could.

At the first break, like a herd of boisterous cattle, we formed a stampede and headed for the restroom.  Of course, the line seemed to stretch at least a mile!  A few of us looked at each other in disgust and disappointment.  Then in our anguished state we rationally sized up the venue.  We realized that given the size of the resort and the fact that we were on the bottom floor, there had to be a bathroom upstairs.  We knew it was a risk, but since we had also seen a few others head upstairs, there was a good chance we would find another bathroom, and it would undoubtedly be less crowded.  We took the risk and we were correct.  The pioneers that ventured up there first had already enjoyed their break, and now our curiosity had paid off.  It was so worth it!!!

This all too familiar situation is actually a lot like the history of alternative investments and how they came about.   For the longest time U.S. stocks and bonds dominated the marketplace.  They were the only bathroom in the building, so to speak.  The correlation between these two asset classes was minimal, and bonds historically provided a safety net in a bear stock market.  Mutual funds later came to the market and offered even better diversification, thereby lowering the single company risk in stocks and bonds.  The next frontier was the ability to invest internationally.  When this became possible, the barriers to invest in markets outside the U.S. were broken.  It was perfect!  There was little to no correlation with the U.S. companies and international stocks provided an excellent way to diversify portfolios.  There were plenty of bathrooms to use!  Soon after it became possible to invest in real estate and commodities, and other sophisticated investments that were in the past off limits to smaller investors.  Mutual funds evolved further to exchange traded funds, and this created fierce price competition and better liquidity, as well as opened the door to investing in specific industries.   This diversified approach has always been built on the expectation that different asset classes will rise and fall in different patterns—in other words, they will be uncorrelated and have minds of their own.  Over time, as companies and lending tactics have become more globalized, it becomes harder and harder to find investments that don’t move in similar patterns.

Maybe Volatility Is Not the Problem

If the equity markets of 2011 could be described in one word, it would be volatility.  Triple digits swings in the market became the new norm, and thus created panic of a double dip recession.  104 days of triple-digit swings out of 252 total trading days will do that to you.   Yet, believe it or not, 2011 overall was not an exceptionally volatile year for global markets.

Let’s review a quick lesson on how volatility is typically measured.  Most analysts use standard deviation, a statistic that measures how widely spread the values are in a set of data.  If a large amount of data points are close to the mean, then the standard deviation is small; if many data points are far from the mean, then the standard deviation is large.  If all the data values are equal, then the standard deviation is zero. 

In 2011, the S&P 500 had a standard deviation of 15.9% — a tad bit lower than the long-term average of 16.3%.  International stocks performed worse and finished 2011 with a standard deviation of 19.7%.  This number is higher than the long-term average of 16.2%.  Yet, it is within the normal range historically.  So, based on this measurement, it wasn’t the worst year for volatility.

So, if volatility really wasn’t off the charts in 2011, what’s all this fuss about it?  We think the reason investors are feeling so much pain in their portfolios is not just because of volatility risk.  It’s also from the high levels of portfolio riskdue to rising correlations among asset classes.  The tools of traditional asset allocation and risk management have become harder and harder to implement in portfolios.   The alternative investment marketplace has evolved to meet this need.   The canary in a coal mine tactic has already been tested.  Now, these low-correlation alternative investments have proven to not only improve a portfolio’s returns, but also substantially reduce the volatility to help avoid these rare and extreme fat tail events. 

All Grown Up Now

This notion of using alternative investments to diversify portfolios is hardly a new one.  Institutional investors, endowments and pension plans have been using alternative investments, such as hedge funds and private equity, for quite a while as a way to gain exposure to unique asset classes and investment strategies.  In some extreme cases, they even allocated more than 50% of their portfolio to them.  But, since the crash of 2008, institutional investors have demanded more transparency and liquidity.  We’ve all seen the news on the big ones that are behind bars now for not being the best at providing this to their investors.  In the past, these types of investments had large barriers to entry.  They were extremely expensive, and the risk reward trade-off was a hard pill to swallow.  Now, regulation has improved and investment managers are gradually making alternative strategies available in regulated vehicles such as mutual funds and fixed income instruments.  Some have even created products in the form of CDs with that all important FDIC insured protection.

As advisors, we are trusted with the proverbial task of building portfolios with the goal of reducing market risk; then being able to deliver returns that match a client’s objectives and risk tolerance.   As fiduciaries, we assemble an investment committee to evaluate these investments, and present them accordingly, because not all alternatives are alike.  It’s important to recognize that alternatives are not a cure-all solution, as correlations and performance characteristics vary substantially among these strategies themselves.  So what’s an investor to do?  Fortunately, by probing into the elements of these investments, we can help determine which alternatives actually deliver on the promise to provide uncorrelated returns and reduce that fat tail event risk.

The Bottom Line

Developed markets currently make up about 75% of the global economy.  Yet, these historically strong economiesare still grappling with uncertainties that may end up slowing the overall growth of the global economy.  This uncertainty could ultimately drag down equity market performance, slow down gross domestic product (GDP) growth, and delay private-sector spending.   This makes for a tough environment to achieve better than average results.  Preservation of wealth and finding opportunities for growth become harder to achieve without thinking outside the box.  Sometimes, it means getting out of the herd and seeking out that other bathroom with the possibility of being rewarded for it.

While no one can predict the future, it is possible that over the next ten years investors may be facing a climate of lower returns due to these uncertainties.  Interest rates are extremely low, and bond yields remain ridiculously unattractive.  This could easily be the next fat tail event, as an unforeseen increase in rates would terrify the bond market.  This doesn’t seem to bother a lot of folks, as money keeps flowing into bond mutual funds.   This could be a very rude awaking for bond investors – especially when this historically has been a safe haven for investing.  Bond investors face further inflationary risk, as yields are still significantly lower than the rate of inflation, which currently is around 3%.  Taxes further reduce this risk, and make it almost impossible to keep up with the cost of living.

Investing should not be characterized as putting your goals at the mercy of market forces, passively riding the ups and downs that come with volatility. There are now ever-widening tools to help increase the probability of meeting these goals and ultimately reduce the overall risk in a portfolio.  The evaluation of these alternatives is critical.  Searching and evaluating strategies leads to finding the appropriate alternatives that provide the diversification that can only come from investments that participate in economic cycles different from traditional assets classes.  Sometimes, you have to get out of line and walk around to find another solution to the problem.  This is the key to discovering where to find relief.