As much as the only constant in life is change, volatility in the markets is always there. However, over the past couple of years, investors have not only had to contend with increased volatility across the stock and bond markets, but they have also had to contend with increased correlation between the two asset classes. This has reduced the level of diversification that can be achieved by combining stocks and bonds alone within the portfolio. As a result, many investors have been looking for additional asset classes or sub-categories of asset classes that can add more diversification to their portfolios and help protect them from increased volatility.
The reason for adding alternatives to your portfolio is not as an alternative asset class but to enhance diversification. Although junk fixed income may be, it still plays an important role in portfolio creation, particularly during periods of high stress when government bonds and especially US government bonds are viewed as a safe haven.
Set your goals
When considering alternatives to add to the portfolio, you should start by identifying the goal you want to achieve. Some of the ways you can determine this could be:
- Less risk than global stocks
- Reducing the loss to a certain percentage within a certain time frame
- Downside protection during periods of market stress
- Returns that do not depend on traditional market movements
This is an important starting point because it will shape your choice of investment and build your portfolio. For us at Schroder Investment Solutions, we want our alternative investments to:
- Half the beta of global stocks
- With correlation between -0.5 and 0.5 for global stocks
This allows us to be more defensive or add more beta (risk) to our alternative investments depending on our view of the market cycle.
The need for real alternatives
Next, consider investments that may come as “alternatives” but may not provide you with the association benefits you want to achieve. The most common investments we see here are thematic investments that include clean energy funds and climate change funds. These give you access to important long-term trends, but should not be included in your alternative allocation because their primary investment is in stocks.
Investment funds should also be treated with caution. Although underlying investments such as private equity, infrastructure or real assets, may have a low correlation with global stocks, an investment vehicle is a listed instrument and is therefore subject to fluctuations that are driven by buyers and sellers in the stock market (known as Equity Beta). Some ETFs show lower equity shares than others due to the composition of their shareholders and underlying assets, but market pressures can cause volatility such as equity. Including investment confidence in your alternatives allocation may make sense from an allocation perspective, but it is essential to properly combine this with more defensive, low-correlation alternatives.
Hedge Funds and CTAs: Alternatives to Consider
Hedge funds are another popular addition to multi-asset portfolios. Hedge funds have their own investment goals and you need to understand how they relate to what you want to achieve.
The charts below show the relationship between different hedge fund strategies and global stocks.
Source: NB Analysis, SocieteGenerale, HFRI, Bloomberg. Correlation data is calculated using monthly returns from January 2000 to December 2019.
Different types of hedge funds offer different levels of protection in your portfolio compared to global stocks during periods of market volatility. It is wise to invest in a basket of low correlation hedge funds that provide the level of downside protection you need.
Funds that aim to generate consistent returns regardless of the general trend of the market can also be useful in portfolio construction. This includes trend-following strategies or CTAs that look for consistent short-term trends in the market regardless of which direction they can exploit to generate a return.
Create investment portfolios for your clients
Some alternatives have properties that are primarily defensive in nature. These can help mitigate losses within the portfolio when global stocks fall in value but are likely to lag in emerging markets.
When creating client portfolios, you need to understand what kind of contribution different alternatives can make to achieving their goals, and mix it up accordingly to help achieve their client outcomes.
To learn more about our investment solutions and how Schroders can support you, visit our website websiteYour usual call, Schroders Actor or call us Business Development Office on me 0207658 3894.
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Originally published at San Jose News Bulletin
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