Investors, both institutional and retail, often invest in alternatives in pursuit of greater diversification or risk reduction; however, alternatives might fail to reliably accomplish these goals.
Typically within a diversified portfolio, stocks outperform bonds, high-grade bonds reduce volatility, and alternative investments that behave unlike stocks and bonds can improve portfolio diversification. This article focuses on alternatives, which includes real estate, hedge funds, private equity, managed futures, and others.
Correlations and Diversification
The common assumption is that alternatives improve diversification because they have low correlations of returns with stocks and bonds. However, investors should also understand what is driving this because low correlation is not the same as diversification. Real estate investment trusts derive value from the underlying real estate, and associated income. As an investment vehicle, this generally has low correlations with diversified stock and bond portfolios. However, some alternatives have low correlations because they concentrate holdings in a few stocks, which is clearly not diversification. Finally, alternatives might appear to have low correlations because they are valued infrequently, creating illusory price stability when calculating correlations.
Investors should also consider additional risks associated with alternatives, including:
- Less Transparency: alternatives typically have fewer accounting, custodial, and regulatory requirements than other publicly traded investments.
- Lower Liquidity: many alternatives require lock-up periods, reducing flexibility and increasing the risk of selling other investments at the worst times.
- Leverage: alternatives might use leverage to boost returns, which substantially increases the overall risk.
- High Fees: fees are frequently around 2% of assets in addition to upside sharing.
- Insufficient Return History: Researchers have studied decades of returns for stocks and bonds to determine statistically significant drivers of returns. However, for alternatives, current data sources may be incomplete and/or survivor-biased.
Investors should evaluate their alternative investment to understand their true impact as it is likely very different than what they have been led to believe.
Josh Clifford, CFA, CPA
Josh Clifford is a part of the Wealth Management team at Austin Asset, a fee-only financial planning firm. As a wealth manager, Josh interacts daily with wealth planners to manage portfolios that strive to meet clients’ financial goals.