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An important goal for most investors is to reduce the effect of volatility and performance swings. They can go about this in a number of ways.
One the most tried and tested has been diversification by mixing asset classes with a low correlation, so that when one asset is not performing positively, the other usually is and vice versa. The traditional way to do this in a balanced portfolio is to allocate 60% to equities and 40% to bonds, because these two assets generally have a low correlation.
Experts say this approach is still an effective way of countering volatility. However, as the market volatility has increased in the last decade or so, so investors have had to look for more tools that can help them maintain smooth returns.
As Vassilis Papaioannou, chief investment officer, Dolfin, says: “The traditional principle of 60/40 still works as a passive way of navigating markets. However, the way people approach diversification has developed and many investors are looking to broaden their investment horizons.”
One of the first developments in this direction was the so-called endowment model – used by institutions such as universities – which looks to achieve higher returns and less risk by moving a portion of assets away from traditional stocks and bonds into other asset classes such as carefully selected hedge funds, private equity, real estate, and other alternatives.
The highest profile example is the Yale University endowment, which increased its allocation to alternatives from less than 30% in 1990 to more than 60% in 2015.
Success of alternatives
This approach has been shown to be successful at increasing risk-adjusted returns and reducing volatility. As Papaioannou explains: “Alternatives such as commodities, real estate and hedge funds are non-correlated with equities and bonds so they provide that extra diversification effect. For example, the average annual volatility in a 60/40 portfolio since 1990 (over a 30 year period) was around 9%. If you had added 15% gold as an alternative, with a 50/35/15 ratio, that would have reduced that volatility by half. Adding other uncorrelated alternatives would have decreased it further. But the selection process needs to be robust and you need expert help to do this.”
The selection process needs to be robust; you need expert help.
Vassilis Papaioannou · Chief Investment Officer
The success of adding alternatives has turned it into big business. According to data provider Preqin, funds invested in alternatives grew $500 billion between 2014 and 2015, up to an all-time record $7.4 trillion, and this trend looks set to continue.
Douglas Cumming, professor of finance and entrepreneurship at the Schulich School of Business at York University in Toronto, runs a course on alternative investments and has authored several papers on the subject.
He says that as well as the attraction of much lower correlations, there are also many more inefficiencies in alternative markets that active managers can exploit to help smooth returns. Cumming says: “Investors will continue to look for market inefficiencies through new types of alternative investments such as venture debt funds and financial technology.”
However, he also warned that the benefits of alternatives might be harder to achieve in future due to the number of hedge fund managers that are now pursuing similar approaches.
Another development on the traditional 60/40 approach has been so-called factor investing, which aims to select securities based on specific attributes (such as size, value, momentum, sentiment). This allows investors to incorporate a higher level of granularity in their portfolios.
Papaioannou says: “Sophisticated investors now consider a wide range of factors in their bid to smooth volatility, including their own risk profile; investment style and level of diversification in terms of both asset class, geography and size.
“After the main allocation, they also then decide on allocation to sub-classes [to achieve more precise non-correlation]. For example, in the bond part, you have sub-sectors such as government or corporate bonds. And in equities, you have developed or emerging markets.”
Active management can smooth performance more precisely.
Vassilis Papaioannou · Chief Investment Officer
Another step is to cross analyse the portfolio to avoid overlaps and other anomalies. “For example, if you don’t want exposure to emerging markets, but you do want commodities, how should you get that?” says Papaioannou. “Should you just buy gold or a commodities index?
“Also in real estate or hedge funds, should you buy specific funds or use products like exchange traded fund (ETFs) to access a whole index? Investors also need to decide how active they want their manager to be. I believe investors should look for the active approach. By monitoring asset classes regularly, active management can minimise the effect of market drawdowns and smooth performance more precisely.”
While alternative investments have proven their worth in terms of increasing risk-adjusted returns and reducing volatility, the complexity of asset allocation in a diversified portfolio has increased. The new models may well be better at taming risk but they demand a higher level of expertise. All but the most sophisticated investor would benefit from an active manager on their side.