Traditional stock and bond market investing provides a solid foundation to an investment portfolio. However, the addition of another low correlated asset class that we call “alternative investments” can take your asset allocation to the next level.
Alts are Next Level
Using alternatives can increase diversification, dampen volatility, provide access to non-traditional markets, and enhanced returns.
Navigating the space can be daunting for individual investors, but ETFs have now made the space more accessible, transparent, and liquid. ETFs have redefined the alternative investment markets back to what they were originally intended to provide: lower correlated investments for more effective asset allocation.
At Stringer Asset Management, we have been investing in the alternative investments space using ETFs for over a decade. Our expectation for the current market environment of relatively muted market returns with greater volatility makes this one of the best opportunities, in our opinion, to use alternative investment ETFs if done so properly.
We focus on creating a basket of alternatives to provide liquidity and diversification to the other asset classes, along with the potential for risk reduction. When done correctly, this basket can help investors achieve an attractive rate of return with potentially less volatility than the traditional equity market and less interest rate risk than traditional bond investments. Even better, the evolution of the ETF universe allows investors to access alternative investment solutions through low-cost and liquid ETFs without the tax filing headaches associated with K-1s.
Why Alternative in this Environment?
We expect slower corporate revenue and earnings growth ahead as the U.S. Federal Reserve tightens their policy through rate hikes and a balance sheet reduction, which creates uncertainties in both the equity and bond markets. Still, we believe that including alternative investments into a portfolio is one area investors should consider that may result in a more consistent return and lower volatility over time.
There is a long-term relationship between the nominal growth rate of the U.S. economy (NGDP) and corporate revenues. The rate of growth for the S&P 500 Index’s revenue was lagging NGDP but recently caught up with NGDP as the following graph suggests.
As a result, we expect an annualized total return for the global equity market in the years ahead of roughly 8%. However, we expect a significant level of volatility in the equity market as well, so we forecast a standard deviation of about 20%.
Meanwhile, interest rates have begun to rise and will likely continue doing so. As a result, we expect a total return for the broad domestic investment grade bond market of 3-4% going forward. Since bonds tend to have some level of volatility associated with their prices, we think that a standard deviation of about 4% is reasonable for bonds.
Our work suggests that a well-diversified basket of alternative investments can earn a total return of approximately 6.5% over the long-term and we anticipate a standard deviation of approximately 13.5% around that return. With those inputs in mind, we can create a risk/return matrix across the three broad asset classes as follows.
Therefore, we expect the most attractive risk-adjusted returns, as measured by the Sharpe Ratio, from the alternative investments space. In addition to attractive risk-adjusted returns, alternative investments tend to have relatively low correlation to the other two broad asset classes. This correlation benefit can also reduce overall portfolio risk. However, it is also important to think about exposures within an alternative investment basket.
What types of alternative strategies work in this environment?
We view the alternative investment universe as basically everything but traditional long-only equity securities and the core fixed income sectors as represented in the Bloomberg Barclays Aggregate Bond Index. Importantly, alternative investment strategies contain not only the risks associated with traditional equity and fixed income markets, but also many other types of unique risks that an investor should consider.
For instance, we think that the differences in U.S. yields compared to comparable yields around the world could lead to the U.S. dollar to appreciate significantly as foreign institutions purchase more U.S. dollar denominated debt.
Assets denominated in U.S. dollars are likely to come under pricing pressure as the U.S. dollar moves higher and the relative prices of these asset move lower (the stronger the U.S. dollar, the more of the asset can be purchased with each dollar all else being equal).
As a result, the prices of many precious and industrial metals as well as emerging market debt could depreciate, so investors may want to limit exposure to those areas of the alternative investments universe.
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Currently, we think investors should focus on U.S dollar-based assets that can thrive in an environment of heightened market volatility that also offer relatively stable yields. These types of strategies include:
Preferred Stocks: These strategies can provide a good relative value compared to other income producing sectors. Since preferred securities are lower than debt issues in a company’s capital structure in the case of default, investors may want to look for a strategy that has an active management overlay to offer the added benefit of bottom-up credit research.
Diversified Multi-Asset Income: These strategies can offer a blend of income producing assets, such as mortgage REITs, preferred, and high-yield bonds. They are diversified blends that offers relatively consistent returns, primarily through an attractive yield, and potentially low correlation to the traditional stock and bond markets.
Options Writing: These strategies typically profit from a higher volatility regime by selling call options on an index. As volatility increases, so does the potential options premium. Additionally, many of these strategies reinvest the premium it receives to potentially increase the fund’s net asset value over time.
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Merger/Arbitrage: These strategies have a history of solid performance in volatile equity environments because of their ability to short equities. Merger/arbitrage investments generally makes their returns based on the price differentials between companies being acquired and those doing the acquiring.
MLPs: We think the energy sector is one of the most attractively priced areas of the U.S. market based on normalized earnings. Given the combination of positive fundamental and technical factors, we expect oil prices to stabilize near or above their current levels. Energy companies should also be able to increase earnings nicely at these levels. Additionally, MLPs can provide a nice yield.
Below is an example of how an investor might allocate these strategies to create a basket of alternative investments. The expected current yield on this basket should get an investor a long way towards our long-term total return expectation of 6.5% for the basket with significantly less volatility than the equity market and less interest rate risk than the traditional bond market.
Importantly, because investors can use ETFs, these alternative strategies offer intra-day liquidity, rather than the longer holdings periods required by many alternative investment vehicles. Furthermore, many of the alternative ETFs are subject to 1099 tax reporting and not the more complicated K-1s. Lastly, using ETFs should be less expensive than hedge funds or even the average alternative mutual fund.
Combined, a well thought out allocation of alternative investment ETFs can offer an attractive risk-adjusted total return, a healthy income stream, less risk than the equity market, and efficient tax reporting in a low-cost product. This type of allocation may be a great solution in today’s shifting economic and market environment.