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Insights: Why Bother Using Alternatives Anyway?
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Why Bother Using Alternatives Anyway?

Research shows small allocations just won’t make much of a difference

Most financial planners say they won’t be adding more alternative investments to their portfolios – and frankly they probably shouldn’t. Especially if they won’t use enough to matter.

Only about 8% of those surveyed by the Financial Planning Association and Longboard believe they will add alternatives in the next 12 months. In this case, alternatives could be anything outside of traditional stocks and bonds.

Who can blame them?

As an alternatives specialist, this data isn’t surprising to me.

Despite a rush into alternatives post-financial crisis, the stock market has recently appreciated at rates much greater than historical averages. Plus, even with ultra-low interest rates, government bonds still are giving investors a small bit of performance.

Compare that to alternative strategies like hedge funds, which have seen at times dramatic underperformance during stock market highs, and it’s no wonder alternatives fail to inspire many investors and their financial advisors.

 

The counter view, backed by data

However, the historical record paints a very different picture of some alternative investments.

That’s why it’s crucial to assess the difference between asset classes that truly diversify against a 60/40 portfolio and DINOs, diversifiers in name only.

DINOs like REITs and private equity both are more than 70% correlated to stocks and bonds, but because these are grouped into “alternatives” they give the entire category a reputation for poor performance in terms of diversification.

On the other hand, true diversifiers are those that historically have delivered both increased returns and lower risk in declining markets. Asset classes like managed futures, MLPs and gold have been true diversifiers because of their 30% or lower correlation to 60/40 during a downturn.

 

How much is enough?

But just investing in strategies with low correlation isn’t enough.

Nearly 3 out of every 4 planners surveyed invests 10 percent or less of their portfolios in alternatives. But Longboard’s research shows that it takes a minimum 20% allocation to true diversifiers to provide the benefits that justify the extra work.

Given this information, should planners bother using alternatives at all? Yes, but only if they’re prepared to use true diversifiers at a high enough allocation over a full market cycle.

Otherwise, these strategies could cause more problems than they solve.

As for convincing your clients to commit to a meaningful alternatives allocation? That’s an article for another day.

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Definitions

Alternative investments: strategies that produce returns by taking risk other than equity and bond risk.

Bond: A debt security that shows ownership in a corporation or represents a claim in the corporation assets and earnings.

Correlation: a statistical measure of how two securities move in relation to each other.

Long: Buying an asset such as a stock, commodity or currency, with the expectation that the asset will rise in value.

Short: Buying an asset such as a stock, commodity or currency, with the expectation that the asset will decrease in value.

Stock: A security that shows ownership in a corporation or represents a claim in the corporation assets and earnings.

True diversifiers: investment strategies that have historically provided investors with at least 70% of the return of the traditional 60/40 stocks and bonds portfolios while having less than .30 bear correlation to traditional 60/40 stocks and bonds portfolios.