Incorporating Alternative Investments
If you had invested $1,000 in a 60/40 stock/bond portfolio at the beginning of 1997, it would have been worth $3,756 at the end of 2016. If you had been able to invest that money in Princeton’s endowment, it would have been worth $10,078--168% more!
The biggest difference?
Princeton has over 70% of their portfolio allocated to alternative investments.
Although alternative investments (alts, for short) may seem elusive to the everyday investor, that is simply not the case. Many alt strategies are affordable and accessible to almost anybody interested in the enhanced diversification they can bring!
Why, then, don’t you see them in your portfolio?
The problem is, most people--and that includes most financial advisors--do not understand them.
I intend to change that (at least for my readers).
After discovering my depressing post on the grim state of world markets, many readers have asked in frustration:
Okay, I believe you now, we're in trouble, but is there really anything I can do about that?
My first goal with this blog was to prove, or at least justify, my concerns. I felt that was necessary before I began offering solutions.
If I did it the other way around, I worried my efforts would be in vain, as many people would not yet grasp the legitimacy and gravity of my perspective.
After hearing from you, however, I see you already recognize the reality that 100 years of market data might not be enough to predict its future fate forever and that sometimes even millennia of data can prove dead wrong. On top of that, you seem just as concerned as I am about today’s historically high stock market valuation.
If I couldn’t find solutions, I’d be scared too!
So I’ll start introducing some simple strategies to help you better protect and grow your hard-earned assets (your life savings).
What Is an Alternative Investment?
The term “alternative investment” is generally used to refer to any asset that is not one of the conventional investment types, such as stocks, bonds, or cash. That could be real estate, private equity, hedge funds, commodities... the list goes on.
Who uses alts?
University endowments make up some of the largest pools of invested assets, and since they have to publicly disclose their returns and allocations, they provide us with some amazing information.
Four of the five largest endowment funds have embraced an alternative investment strategy. Over the past couple decades, each shifted their portfolio from an allocation very close to the traditional 60/40 paradigm to an alternative focus.
Those four university endowments are:
The performance of these portfolios over the long run has been nothing less than impressive.
Over the last 20 years, Harvard averaged a 10.4% return; Yale, 12.6%; Stanford, 10.7%, and Princeton, 12.3%.
Let’s compare the performance of those endowments with that of the traditional portfolio. The S&P 500 Index averaged 7.7% per annum, while the Barclay’s Bond Index averaged 5.3%. Thus, the traditional 60/40 portfolio had an annualized 6.8% return.
Aside from the fact that this 6.8% return does not account for fees, it also may be a generous estimate for near-future growth. Today, due to the aforementioned high market values and low interest rates, many institutions tend to project lower-than-historical returns over the next several years.
Goldman Sachs in 2016, for example, projected that a 60/40 portfolio would average 2.2% over the following five years.
How were their returns all so high?
Is it coincidence that each of the endowments embracing alternative investments substantially outperformed the traditional benchmark?
Are their managers just that good?
Whatever the reason, we should definitely consider how their asset allocation compares to ours. Consider the mainstream recommendations from financial advisors and the talking heads on TV of 60% stocks and 40% bonds (or some derivation therein).
It’s worth noting that these returns are after of the endowment managers’ hefty fees.
These four universities are not alone
Here are the average allocations to alts for different types of investors.
- The average pension funds invests 27% of its portfolio in alts.
- The average endowment invests 29% of its portfolio in alts.
- The average individual invests only 5% of her portfolio in alts.
Much of this discrepancy can be explained by the fact that alternatives used to be inaccessible to the average investor. You could only find hedging and alternative strategies in hedge funds, and those are only available to accredited investors--individuals worth more than $1MM (excluding the value of their home) or making over $200,000 per year.
Today, however, many alternative investments are accessible and affordable.
Because there is now a market for them, mutual funds and exchange-traded funds have risen to fill the void. This has made many alt strategies available to the masses, and there are plenty that offer viable enhanced diversification at a reasonable cost.
Why, then, do I not already have them in my portfolio?
Many Advisors Do Not Understand Alts!
Most investors--including many financial advisors--don’t understand alternative investments.
A graphic created by Blackstone in November, 2016 from a Morningstar Survey tells the story:
48% of the advisors and individual investors surveyed admitted to a “lack of understanding” when it came to alternative investing. This is in stark contrast to the 15% of institutions--and we’ve seen from the university endowments how this “understanding” has paid off for them.
How Could You Gain Alt Exposure?
There are many types of alternative investments out there--remember, an alt is pretty much anything that is not one of those conventional assets: stocks, bonds, or cash. Luckily, you don’t need to know or understand all of them.
My "accessibility and affordability" claim is true for some specific alternative investment types, but not all. For example, private equity and venture capital are fun, sexy subjects within the alt universe, but they’re still pretty risky, expensive, and relatively unavailable to the average non-accredited investor.
I will dive into the specifics surrounding many of these alternative strategies in future posts. If you just can’t wait, however, and absolutely must learn more now, these are the four fund types I suggest you explore:
- Long/Short Equity
- Market Neutral
- Managed Futures
Those first two, long/short equity and market neutral funds, utilize an investment strategy known as “shorting,” which allows them to potentially profit during market declines. Commodity funds tend to move independent of traditional stock funds and work as a hedge against inflation. Finally, managed futures are relatively more complex--they offer a unique diversification which can thrive during times of market chaos!
The US News & World Report mutual fund search is an easy-to-use tool for evaluating different options. (Keep an eye on the expense ratios. Specifically, you might want to scan the prospectus of any managed futures fund you are considering; there can be obscure fees buried in those funds.)
Incorporating some alternative investment strategies into your portfolio allocation can provide unique growth opportunities as well as enhanced diversification to reduce drawdowns during market declines.
Let me know your thoughts
- What causes you to hesitate from diversifying your portfolio with alternatives?
- If you have experience working with inexpensive alternative investment funds, do you have any additional recommendations/suggestions for those interested in pursuing such strategies?