In our first article in this ETF Strategist series, we discussed a number of common current concerns among financial planning clients. These concerns can be collectively described as the “portfolio problem,” and more briefly recapped as follows:
- Equities are, arguably, the single most essential component of client portfolios — they represent the growth engine, the asset class most likely to keep clients ahead of inflation and allow their financial plans to succeed — but equities are subject to substantial volatility and significant downside risk
- The other asset classes in the portfolio — a primary purpose of which is to buffer the risk of the equity asset class — have become problematic and detrimental to portfolio performance
With respect to these other asset classes, our second article in the series focused on fixed income investments. In this third article, we turn our attention to the next most prominent non-equity asset class in most client portfolios: liquid alternatives.
Alternatives represent quite a diverse asset class, but generally include investments whose purpose is to provide a return (and risk) between that of equities and fixed income, and behavior uncorrelated with either asset class. We have heard some portfolio managers characterize their ideal “alt” as having an expected return of two-thirds that of equities but with only half the volatility. Alts had their birth in the world of hedge funds, and populating that space are such strategies as market neutral, absolute return, long/short (or hedged) equity, global macro, and various others, including hybrids. Liquid alts are those available to retail investors in forms such as ’40 Act mutual funds, which do not require the level of accreditation on the part of the investor, the lengthy lock-up periods, the exit gates, the high fees, or the large minimum investment amounts that typify hedge funds.
Over the last few decades, and spurred in part by the widely reported success of illiquid alts in the portfolios of several prominent university endowments, liquid alts have achieved mainstream status in the portfolios of non-institutional investors. They are now considered the third major asset class among retail investors, along with equities and fixed income.
In the context of the portfolio problem above, there are two concerns we have with the current state of liquid alts.
Our first concern is that with the growth in popularity of liquid alts has come a disturbing trend toward mediocrity. Now, given the diversity of strategies within this asset class, one must be careful not to paint its picture with too broad a brush; but, there is sufficient evidence based on the aggregate indexes that attempt to track performance of this class to give a discerning investor pause. The chart below plots the total return of three prominent indexes in the alt space compiled by Hedge Fund Research, Inc. (HFRI): the Equity Hedge Index, the Equity Market Neutral Index, and the Fund of Funds Composite Index. The returns shown are the average annual returns calculated on a rolling 60-month basis to reduce short-term “noise,” smooth out the effects of bull/bear market cycles, and make clear the long-term trend. The data series extends through December 31, 2015.
Source: Giralda Advisors analysis of Bloomberg data
This picture, while far from predictive of course, concerns us. In our view, it indicates that liquid alts are co-culprits with fixed income investments in being prime contributors to the portfolio problem we cited above.
Our second concern is that liquid alts appear to be losing whatever diversification benefit they may have had. The chart below, using the same three HFRI indexes we just introduced, plots the rolling 60-month correlations of each of these indexes with the S&P 500 Stock Index.