October 2024
2022 was a watershed year in financial markets. After the inflation surge of 2021 central bankers responded by tightening monetary policy in a bid to cool the economy and tame inflation. Having been initially slow to react, the Federal Reserve had to ramp up interest rates in 0.75% increments, the most aggressive increases since the 1980s.
The 60-40 Portfolio Under Fire
For investors the sharp increase in interest rates created a perfect storm. Investors who believed bonds were a low risk asset got a shock and anybody thinking the widely endorsed 60-40 (stock/bond) portfolio was an all-weather approach was bitterly disappointed. Bond markets plunged as interest rates increased and equity markets fell as economic prospects darkened.
US 60-40 Stock/Bond Portfolio
Why Consider Alternatives?
Alternative investments like hedge funds had been touted as a possible remedy for the shortcomings of the 60-40 portfolio. Because such funds use active strategies and trade many markets, they can generate returns at different times as equities and bonds i.e. they have a low correlation.
From a portfolio perspective, the hope is that they can provide balance to a portfolio by generating returns in the periods when equities and bonds are challenged, such as when inflation is rising or economic growth is weakening.
2022 was the acid test. Fortunately, many alternative funds, particularly global macro and managed futures strategies, performed strongly. For example, the SG CTA index, an index of funds trading financial and commodity futures, was up 20%.
Taking More Risk to Reduce Portfolio Volatility
Yet, even for investors who allocated to these strategies, whether they fully capitalised on the opportunity and protected their portfolios really came down to one key question: did they take enough risk?
The potential impact on returns from not taking enough risk is well understood. If you keep your money in cash or T-Bills you have safety but your portfolio won’t grow much over time. It may even fall in value when adjusted for inflation. Investing in the stock market offers higher potential returns but with a risk.
But the idea of taking more risk to manage and even reduce portfolio risk is less appreciated.
Mathematically, it is easy to prove that if an alternative fund has a low correlation to bonds and equities, adding an allocation to the fund will reduce the volatility of the portfolio.
From our interactions with hundreds of investors over the years the main question that they grapple with is how much to allocate to alternatives. 2%, 5% or 10%? How much is needed to “move the needle”? They understand that just like an effective team needs a balance between defence, midfield and attack, for a portfolio to be balanced, the allocations must be sized correctly.
However, the percentage size of the allocation is only part of the portfolio allocation equation: the risk or volatility of the fund also matters.
Allocating to Higher Volatility Alternatives
Investors are often conditioned to search for solid return, low volatile investments. However that mindset could be counter productive when it comes to selecting alternative funds. Because equities are volatile, and equities are at the core of most growth-orientated portfolios, higher volatility alternatives may do a better job of balancing risk.
This may seem counterintuitive but if you think of alternatives like an insurance policy it may be less so. If your house is flooded, the value of your assets has taken a hit. Having no insurance results in the biggest loss and if you insure your house for too little, it won't fully compensate you. The insurance or diversification has to be effectively sized.
Put another way, say we have another year like 2022 where bonds and equities fall and a typical 60-40 portfolio is down -10%. And let’s say an alternative fund is up 10% for the year. If an investor had taken 5% from the 60-40 portfolio and allocated to the alternative fund, the portfolio return for the year improves, but only marginally from -10% to -9%.
However, if there was a higher volatility version of the same fund, let’s say it was twice as volatile, and the investor instead allocated 10%, the portfolio return now improves from -10% to -7%. By seemingly taking a big risk, making a higher allocation to a much more volatile fund, the investor has managed to cut the decline in the value of the portfolio meaningfully in this scenario.
Yes, when viewed on a standalone basis the higher volatility fund is riskier but that is not necessarily the case when considered in the context of the overall portfolio. The primary determinant of whether it adds to portfolio risk or not is the pattern of returns (i.e. its correlation), while the size of the impact is driven by the volatility.
Conclusion
In today’s increasingly uncertain market environment, it is crucial for investors to look beyond traditional asset allocations and consider alternative investments. By taking calculated risks and incorporating higher volatility alternatives, investors can not only seek to enhance returns but also better manage portfolio risk.
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