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Why Alternatives Should Be Part of Your Investment Portfolio

Ketan Bhalla | July 07, 2016


When individuals think of their investment portfolio, they tend to think of more traditional asset classes: fixed income (bonds) and equities (stocks).   Historically, individual investors have not had easy access to alternative asset classes, such as hedge funds, real estate, private equity or venture capital.  However, with the emergence of online investment platforms and the rapid advancement in the fintech industry, many alternative asset classes are now available to accredited investors at manageable minimums, allowing them to further diversify and potentially enhance their investment portfolio.  The next obvious question is: why invest in alternative asset classes in the first place?

Portfolio Diversification – what does it all mean?

By diversifying your portfolio across different types of investments, you hope to primarily do two things: a) protect yourself during market downturns and b) participate in positive markets while taking less overall risk.  Said differently, diversification should lead to lower volatility for your overall investment portfolio.  Lower volatility is important because, all else being equal, it allows your portfolio to compound more quickly over time and could have a significant impact on the cumulative return of your portfolio.  Frankly, it also helps from a “peace of mind” perspective – not having your investments rise and fall rapidly in conjunction with major market swings may give you more conviction to stick with your investment strategy over the long term.  Think about it in the context of having “many eggs in many baskets”.

One of the more traditional benchmarks for a “diversified” portfolio is what is known as the “60 / 40 Portfolio”.  This means that 60% of your portfolio is invested in stocks and 40% of your portfolio is invested in fixed income.  Of the two asset classes, equities are considered “riskier” (in part due to higher historical volatility) but also present the most upside potential.  Fixed income, on the other hand, is considered less risky and tends to provide a more stable return profile.  Obviously this is just a baseline – younger investors who have a longer investment horizon tend to be more heavily invested in equities since they can withstand additional risk in order to try and achieve higher growth.  Older investors, on the other hand, tend to be more invested in fixed income since their investment horizon is shorter.1

Got it – but why add other alternative asset classes?

Adding alternatives can provide diversification benefits because they tend to have a low correlation to traditional asset classes and also may have lower volatility than equities.  Both of these features may make them attractive portfolio additions, but need to be balanced with the fact that alternatives also tend to give you less liquidity than traditional asset classes.  Unlike stocks or bonds, you generally cannot buy and sell alternatives freely on a publicly traded (or even privately traded) market.  This liquidity characteristic is why alternatives tend to be a smaller allocation for individuals in a “modern portfolio” compared to stocks and bonds.

It should also be noted that there is no standard definition for “alternatives” – many people define the asset class differently.  Personally, I like BlackRock’s definition the most: “core diversifiers, sources of potential return and investments that provide risk exposures that, by their very nature, have a low correlation to something else in an investor’s portfolio.”2

These characteristics are visualized nicely in this chart by J.P. Morgan3:


This chart is your typical “efficient frontier” which plots risk (volatility) on the x-axis against return on the y-axis.  Here you can see that adding an allocation to alternative investment strategies has historically increased returns without an increase in volatility, which is precisely what you would want in an investment.

Another thing to note is that institutional investors, who are often viewed as the “smart money”, have been using alternatives for quite some time to help diversify their investment portfolio and attempt to enhance their returns.  In fact, according to the 2015 NACUBO-Commonfund Study of Endowments, endowments allocated 29% of their total investment portfolio to alternative strategies on average.4

Cool.  Can private company investments be considered “alternatives”?

In our mind, private company investments are a core piece of the overall “alternatives” landscape because they fit the characteristics defined above.  Unfortunately there is not a specific pre-IPO company index out there, but we can use a few widely accepted indices as a proxy to illustrate the impact of adding private companies to an investment portfolio.

Specifically, if you look at the Cambridge Associates Venture Capital Fund Index, you can see that it has a 0.42 correlation to the S&P 500, calculated quarterly, since Q1 19905 and therefore should act as an investment portfolio diversifier.  For the uninitiated, a correlation of 1.0 would be perfect correlation (i.e. the asset classes move in lockstep with one another).

In addition, if you look even more specifically at the U.S. Venture Capital - Late & Expansion Stage Index, you can see that it has generated excess returns of 2.5%, 0.41%, and 5.5% over the S&P 500 over the past 3, 5 and 10 year periods, and has actually outperformed the S&P 500 over almost every period over the last 30 years.6

While these indices are not a direct proxy for late stage, pre-IPO companies, we do believe that they carry similar characteristics and we believe that allocating a portion of your public equity exposure to private companies makes sense for diversification purposes.  However it should be noted that investing in private companies does involve a fair amount of risk and, like any other investment, investors should be cautious of making an outsized investment in a single company.  Further, no individual security can be expected to behave as the sum of the components of an index and individual securities may have no performance correlation with an index.

Summary

We believe that alternatives do have a place in individual investor portfolios because they provide a source of return diversification that is difficult to replicate with traditional asset classes.  With the emergence of online investment platforms that offer access to alternative investments at reasonable minimums, individuals now have the ability to invest in asset classes that were previously accessible only to the largest endowments and pension plans.  More individual investors should take advantage of the opportunity to allocate a portion of their portfolio to these types of investments.


Endnotes
1 Source: Fidelity.  https://www.fidelity.com/learning-center/investment-products/fixed-income-bonds/diversify-your-portfolio.  Accessed on June 6th, 2016.

2 Source: BlackRock.  “The New Diversification: Open Your Eyes to Alternatives, A Conversation with Dr. Christopher Geczy”, Page 8.  https://www.blackrock.com/es/literature/brochure/open-your-eyes-to-alternatives-conversation-with-chris-geczy.pdf.  Accessed on June 6th, 2016.

3 Source: J.P. Morgan Asset Management.  U.S. Guide to the Markets, Q2 2016, Page 55.  https://am.jpmorgan.com/blob-gim/1383280028969/83456/jp-littlebook.pdf.  Accessed on June 6th, 2016.

4 Source: National Association of College University Business Officers.  2015 NACUBO-Commonfund Study of Endowments.  “Asset Allocations for U.S. College and University Endowments and Affiliated Foundations, FY2015”, http://www.nacubo.org/Documents/EndowmentFiles/2015_NCSE_Public_Tables_Asset_Allocations.pdf.  Accessed on June 7th, 2016.

5 Source: Cambridge Associates and Standard and Poor’s.  Venture Capital returns sourced from Cambridge Associates’ “U.S. Venture Capital Index and Selected Benchmark Statistics”, Page 5.  http://40926u2govf9kuqen1ndit018su.wpengine.netdna-cdn.com/wp-content/uploads/2016/05/Public-2015-Q4-US-Venture-Capital.pdf.  Quarterly S&P 500 Index returns were calculated based on monthly total return figures provided by Standard and Poor’s.  http://us.spindices.com/indices/equity/sp-500.  Correlation and quarterly S&P 500 Index returns calculated by EquityZen.  Both links accessed on June 7th, 2016.  Past performance is not indicative of future results.  It is not possible to invest directly in an index.

6 Source: Cambridge Associates and Standard and Poor’s.  Venture Capital returns sourced from Cambridge Associates’ “U.S. Venture Capital Index and Selected Benchmark Statistics”, Page 3.  http://40926u2govf9kuqen1ndit018su.wpengine.netdna-cdn.com/wp-content/uploads/2016/05/Public-2015-Q4-US-Venture-Capital.pdf.  Accessed on June 7th, 2016. 

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