Introduced by Harry Markowitz in the 1950s, diversification is the concept of spreading your investment dollars into a variety of asset classes in an effort to increase return for a given level of risk. Beyond the concept of diversification by asset class or securities, however, Markowitz’s contributions to modern portfolio theory included the idea that risk and reward is not only a function of a portfolio’s individual holdings, but also how those holdings behave with respect to one another1, a concept known as “correlation.” A measure of the synchronicity of movement between components of a portfolio, correlation is scaled between – 1.0 and +1.0.
For example, securities with returns that tend to move in the same direction over time are said to be correlated (with correlation values > 0, but no higher than 1.0), while securities with returns that tend to move opposite of one another are said to be negatively correlated (with correlation values < 0 but no lower than –1.0). Lastly, securities that tend to move independently of each other have little or no correlation (with correlation values around 0). Logically, portfolios of securities that demonstrate a low correlation to one another may be desirable given their potential for greater returns over time, with lower levels of risk. While important to understand the direction and timing of moves, correlation does not convey the magnitude of these moves.
While many investors have traditionally sought to achieve diversification by investing in a variety of securities, assets classes and geographies, for years, institutional investors have sought to enhance diversification using various types of “alternative investments.” Non-traditional investments that have historically demonstrated a low sensitivity to stocks and bonds, alternative investments, in the form of hedge funds, first made an appearance in the early 1950s.2 Designed to help enhance returns, reduce volatility, or potentially both, alternative strategies have helped institutions, and those of high-net-worth, to diversify their sources of risk, while potentially tapping new sources of investment returns.
While alternative investments encompass a wide array of securities and strategies, Morningstar groups alternatives into the three broad categories3, each designed to help achieve particular goals within a portfolio:
- Non-traditional asset classes such as currencies and commodities;
- Non-traditional strategies that incorporate different portfolio management techniques, such as the use of derivatives, leverage and shorting;
- Assets that are not regularly traded on an organized exchange, such as private equity and private debt
- Another important consideration, in addition to selecting strategies with low correlations, is including strategies in a portfolio that demonstrate a low level of volatility relative to traditional asset classes. For example, an alternative strategy and a traditional equity strategy that have a moderate correlation, but the same level of volatility, do not offer the same degree of diversification as would an alternative strategy that is moderately correlated with the equity strategy but whose volatility is much less than that of the equity’s. It is the combination of correlation and relative volatility that truly provides a portfolio with strategies that do not move in sync, and this is known as beta. Market beta, or sensitivity of the portfolio returns to the overall market, is now well known as the factor in William Sharpe’s Capital Asset Pricing Model. This is a very important foundation on which all factor investing is based: that there are systematic sources of return that can help inform portfolio construction.
Alternative investment strategies, that make use of different portfolio management techniques, may provide a better opportunity to diversify a multi-factor portfolio among both traditional and alternative sources of returns. Conceptually, this is similar to the reason one would mix fixed income and equity in the same portfolio: to target a desired level of risk and exposure to specific sources of returns.
When implementing alternative strategies, however, a portfolio manager may use different tools that allow him to trade the same underlying equity or fixed income securities, but in a different manner, thus generating a different return profile.
For example, the use of derivatives, such as futures contracts, allows a fund manager to specifically calibrate its sources of risk and expected return. Derivatives also allow a strategy’s returns to be “levered up” in order to magnify the level of returns by gaining more economic exposure to a strategy than the amount of dollars available for investing could have otherwise.
Finally, shorting strategies have a dual benefit. First, taking a short position is equivalent to locking in a price and thereby achieving a hedged position in a portfolio. In addition, a fund may profit by selling shares of a security that were borrowed, and then, at a future point in time, buying the same quantity of those shares, hopefully a lower price, in order to replace the shares that were borrowed. If successful, the investor will profit on the difference between the selling price of the borrowed shares, and the cost of the shares that were purchased as replacements.
While alternative investments have historically offered the opportunity to enhance returns while potentially mitigating risk, they do have a unique set of characteristics and risks including the potential magnification of gains and losses. Additionally, alternatives have historically been available exclusively in Limited Partnership vehicles, which have important differences from 1940 Act funds. These more complicated legal structures frequently have high minimum income and net worth requirements, higher fees and expenses, as well as a lack of liquidity given the lock-up periods that are often required. Similarly, these fund structures may lack transparency with respect to the portfolio holdings, or investment strategy. Given these tendencies, the availability of alternatives has been traditionally limited to institutional and high-net-worth accredited investors.
While alternatives have traditionally been the domain of sophisticated and high net worth investors, alternative strategies are now available to individual investors in the form of liquid mutual funds and ETFs. If properly constructed, the strategies in these funds may achieve the performance and risk mitigating characteristics of an alternative strategy, but with lower cost, inherent liquidity, and greater transparency.
Just as with most investments, however, liquid alternatives are not for everyone. While they may help dampen overall portfolio volatility in turbulent markets, thereby helping some to stay the course in times of distress, for many, alternative investments remain somewhat of an enigma. Secondly, while offering the opportunity to enhance portfolio returns and mitigate risk, investors must be willing to accept periods of below market rates of return, as alternatives should have a low equity market beta in both up and down markets, in an effort to capture a different and unique set of return premiums.
To learn more about alternative investing, or to see if these strategies may be right for you, please contact us with questions or for additional information.
Content written by Symmetry Partners, LLC. Our firm utilizes Symmetry Partners, LLC for investment management services. Symmetry Partners, LLC, is an investment adviser registered with the Securities and Exchange Commission. The firm only transacts business in states where it is properly registered, or excluded or exempted from registration requirements. All data is from sources believed to be reliable, but cannot be guaranteed or warranted. No current or prospective client should assume that future performance of any specific investment, investment strategy, product or non-investment related content made reference to directly or indirectly in this article will be profitable. As with any investment strategy, there is a possibility of profitability as well as loss. Please note that you should not assume that any discussion or information contained in this article serves as the receipt of, or as a substitute for, personalized investment advice from Symmetry Partners or your advisor.
Diversification seeks to improve performance by spreading your investment dollars into various asset classes to add balance to your portfolio. Using this methodology, however, does not guarantee a profit or protection from loss in a declining market. Past performance does not guarantee future results.
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