Why Alternatives?

WHY ALTERNATIVES?

Alternative investments have experienced considerable growth over the last decade, with the market expanding by 11% per year.2 Looking ahead, alternative investments are expected to grow further as investors continue to search for solutions that can diversify and complement a traditional portfolio of stocks and bonds. Yet for all the attention given to alternative investments, they remain somewhat of an enigma. A survey found that 68% of advisors say their clients do not understand alternative investments and 24% believe alternatives are too complicated to explain to clients.1 At the same time, 76% of individual investors say they would consider alternative investments if their advisor recommended them.1 We believe education for advisors and their clients on the types of alternatives available and how they may be used to complement traditional investment strategies will help to bridge this gap.

 

 

 

 

CHANGING MARKETS, CHANGING OPPORTUNITIES

Investor goals are timeless. Whether planning for retirement, saving for a vacation home, or putting children through college, there are three main goals investors seek to achieve for their portfolios: growth, income and diversification. While investors have historically relied on a combination of traditional stock and bond investments to meet these objectives, strong market headwinds may challenge the performance of traditional investments going forward. Alternatives may help.

 

1. SLOWING GROWTH

Growth is a cornerstone of every investor’s portfolio. However, global growth rates have declined over the last 50 years. With few signs to suggest that this trend will reverse course in the near term, we believe investors will need to prepare their portfolios for a lower-for-longer growth environment. Over the past half-century, strong GDP growth has been a key driver of U.S. equity returns, helping to boost both revenues and corporate profitability. In recent years, a simultaneous decrease in the working-age population (fewer workers in the workforce) and productivity growth (less output per worker) has caused economic growth to slow. U.S. GDP growth averaged just 1.8% between the first quarter of 2015 and the first quarter of 2016, compared to more than 2.9% between 1965 and 2014.3 , 4 As the chart below shows, the slowdown in U.S. economic growth is not just a shortterm phenomenon — it has been slowly trending lower for more than 50 years.

 

 

Source: International Monetary Fund, Global Financial Stability Report, April 2015.

 

 

Two primary indicators suggest GDP growth could remain sluggish in the years ahead:

• A shrinking U.S. labor force. Currently, one-third of the U.S. labor force is 50 years or older and approximately 10,000 Baby Boomers enter retirement every day.4 , 5 U.S. population growth has declined to 0.9% per year over the past decade, from 1.1% per year over the prior two decades, and is expected to slow to 0.7% per year over the next 20 years.4

• Stalling productivity. Productivity growth is on the decline. Between 2007 and 2015, productivity growth, at just 1.2%, fell to its lowest level in more than 30 years.6 Without large productivity gains, U.S. economic growth will likely

 

2.  LOW YIELDS

Aside from a few minor corrections, interest rates have been on the decline for more than three decades. Low inflation and accommodative monetary policies pushed the yield on the 10-year Treasury note from over 15% in 1981 to as low as 1.61% in 2012. Although the U.S. Federal Reserve raised interest rates in December 2015, other central banks around the world remain highly accommodative. As a result, global interest rates may remain low for some time. As the history of the 10-year Treasury yield shows, bonds may not be able to provide an adequate level of income in today’s low interest rate environment. Moreover, when interest rates do finally normalize, traditional fixed income investments may suffer losses as rate increases diminish the value of fixed rate holdings over the short term.

 

 

Source: Bloomberg, as of June 30, 2016.

3.  NEED FOR DIVERSIFICATION

RISING CORRELATIONS

One inherent challenge to building a diversified portfolio in today’s market is finding investments that provide an attractive rate of return and behave differently than other assets in a portfolio. Correlation measures the degree to which assets move together and is measured on a scale from -1 to +1. Positively correlated investments move in the same direction. Negatively correlated investments move in the opposite direction. Before the 2008 financial crisis, many investors believed that a portfolio composed of 60% equities and 40% fixed income provided sufficient diversification. However, stocks and bonds are now more correlated than they were in the past, causing many to reconsider this strategy. As the chart below shows, correlations across stocks and bonds have increased since the crisis. Emerging market equities, U.S. Treasuries, emerging market bonds, emerging market government bonds and U.S. high yield bonds are all now more correlated to U.S. stocks than they were in the past.

 

 

Note: Pre-crisis period denotes January 1, 1997, to June 30, 2007. Post-crisis period denotes January 1, 2010, to December 31, 2014. Source: International Monetary Fund, Global Financial Stability Report, April 2015.

 

 

INCREASED VOLATILITY

Financial markets have also become more volatile. The chart below shows that the number of days the S&P 500 moved 2% or more has risen dramatically over the past two decades. There were 422 days when the S&P 500 moved 2% or more between 1996 and 2015, compared to 254 episodes in the previous 40 years combined.

 

 

Source: Bloomberg

Just as stocks have experienced increased volatility, bonds have also undergone periods marked by increasingly large price swings. The chart below shows two periods of recent bond market volatility, as measured by the Merrill Lynch Option Volatility Estimate (MOVE) Index — the June 2013 “Taper Tantrum” and the early 2015 volatility in U.S. Treasuries. Typically thought of as safe-haven investments, government bond volatility rose 46% in June 2013 and 40% in the first six weeks of 2015. Both periods suggest that bond markets (even safe-haven investments such as U.S. Treasuries) have become increasingly susceptible to quick shifts in market sentiment.

 

 

Source: Bloomberg, Merrill Lynch Option Volatility Estimate (MOVE) Index. The MOVE Index measures bond market volatility based on the prices of options contracts on one-month Treasury bills.

A flood of central bank accommodation and ultra-easy monetary policies over the past several years is thought to have acted as a shock absorber for the financial markets, helping to dampen volatility. As the U.S. Federal Reserve’s monetary policy tightens, volatility could persist or potentially increase as markets adjust to an interest rate tightening cycle and attempt to anticipate future rate moves.

THE SPECTRUM OF ALTERNATIVES

A common mistake is to treat alternative investments as a single, homogeneous asset class. Alternatives include a spectrum of assets, strategies and structures, each designed to deliver specific benefits. We believe that investors should consider alternatives based on their goals, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Although there is no universal definition, alternatives cover a range of asset classes and investment structures that broaden the available opportunity set beyond traditional investments. Some common examples of alternatives include:

Private equity:

High net worth individuals and institutions may invest in private equity funds, which purchase and grow private companies. Private equity funds can also provide financing to companies seeking to expand, enhance operational efficiencies and make capital structure improvements, usually in exchange for common equity.

Senior secured loans:

Senior secured loans are the primary source of debt financing for private companies. These loans are typically “secured,” or backed, by a company’s assets. They also typically have floating rates, which adjust with changes in market interest rates.

Real estate

For purposes of investment, real estate generally refers to commercial real estate. Institutional investors, such as endowments and pension funds, may own commercial real estate directly with the goal of achieving rental income. Smaller investors may access real estate through single manager or fund of funds investment vehicles.

Venture capital

Venture capital aims to provide financing to promising start-up and early-stage companies in exchange for an equity ownership stake.

Hedge funds

Hedge funds are private investment pools that typically invest in a wide array of assets across many markets. They may short-sell securities, use leverage to enhance returns and utilize derivatives.

Managed futures

Managed futures are investment funds managed by commodity trading advisors (CTAs) that trade futures on commodities, global currencies, interest rates, equities and energy.

Event-driven credit

With event-driven credit, an investment is made in the debt of companies experiencing a corporate event, such as an acquisition, merger or reorganization, that may result in market price inefficiencies.

 

 

THE VALUE OF ALTERNATIVES

Because alternative investments tend to have lower correlations to traditional investments, and may offer higher yields, they can potentially reduce overall volatility and could help a portfolio perform better through varying market conditions.

Alternatives as a complement to traditional portfolios

By focusing on a specific investment objective, investors can make a more informed decision regarding which alternatives to employ. For example, investors seeking to mitigate the risk of rising interest rates and diversify a traditional bond portfolio might look to senior secured loans. Growth-oriented investors looking to earn a higher return in exchange for a certain amount of illiquidity might consider private equity. Incorporating alternative strategies into traditional portfolios can help meet specific investment objectives.

 

 

 

 

Investing in alternatives is significantly different than investing in traditional investments such as stocks and bonds. Generally, alternatives are often illiquid and highly specialized. When building a portfolio that includes alternative investments, investors and their financial advisors should first consider an individual’s financial objectives. Investment constraints such as risk tolerance, liquidity needs and investment time horizon should be determined. 11 In the context of alternative investments, higher returns may be accompanied by increased risk and, like any investment, the possibility of an investment loss. Investing in alternative assets relies less on publicly available data and more on a manager’s ability to analyze and underwrite its investments. Therefore, alternative investments may be subject to higher costs and fees than traditional investments. Investors should be aware of the benefits and risks of each investment and seek the advice of a qualified investment advisor before investing.

Risk and reward of alternatives

Although alternative investments have varying risk and return profiles, they may contribute to improved overall portfolio returns due to their lower correlation to traditional investments and their potential for providing attractive risk-adjusted returns. The chart below shows the risk (standard deviation) and reward (average annualized returns) of stocks, bonds and select alternative investments. In this example, stocks returned, on average, approximately 8.0% over a 20-year period but exhibited high levels of volatility. Bonds, on the other hand, returned approximately 5.5% but exhibited far lower levels of volatility. Given their varying risk and reward profiles, adding alternative investments may help improve the risk and reward characteristics of an investment portfolio.

 

 

 

The potential benefits of alternative investments

To understand the effects that adding alternatives can have on a portfolio’s performance, it is useful to look at a sample efficient frontier. The chart below shows a set of optimal portfolios that offer the highest return (defined as average annualized return) for each level of risk (defined as standard deviation).

 

 

In this example, the black curve depicts an efficient portfolio consisting of different weightings of stocks and bonds. In this case, a portfolio of 80% stocks and 20% bonds has returned nearly 7.5% over the past 20 years — but the expected risk is somewhat high. Conversely, a portfolio of 80% bonds and 20% stocks exhibits less risk. However, the expected return is lower. The orange curve shows the effect of adding a 20% allocation to alternative investments (in equal weightings of real estate, private equity, managed futures and senior secured loans). As shown, including alternative investments shifts the curve upward and to the left. Based on the historical data used in the chart above, for any given level of risk, the return was higher. While the above example is meant to illustrate the potential benefits alternative investments can bring to traditional investments, returns will vary depending on which alternative investments are included, their weightings, risk profiles and the investment time frame. Because alternative investments tend to have lower correlations to traditional investments, and may offer higher yields, they can potentially reduce overall volatility and could help a portfolio perform better through varying market conditions.

 

 

ACCESSING ALTERNATIVES

A number of large endowments have allocated a large percentage of assets to alternative investments. Yale University, which posted an 11.5% return for 2015, is one of the most often cited examples. Between 2005 and 2015, Yale’s average return was 10%, while U.S. stocks returned an average of 7.9% and U.S. bonds returned an average of 4.4%.7.

 

 

Yale’s strong performance is believed to be due to its willingness to allocate a sizable portion of its portfolio to alternative investments, which, as of June 30, 2015, comprised approximately 74% of its overall portfolio. Citing “their return potential and diversifying potential,” Yale reinforced its support of an investment strategy that emphasizes a heavy allocation to nontraditional asset classes in its 2015 endowment update. Although a portfolio composed of a 74% allocation to alternative investments may be appropriate for a large endowment like Yale’s, such a sizable allocation may not be appropriate for an individual’s portfolio. While large institutions have been raising their allocations to alternative investments, individuals have far different liquidity needs and investment goals than large university endowments. Historically, alternatives have been relatively difficult for individuals to access due to large minimum investment requirements, strict suitability rules, lower liquidity levels and long lock-up periods. In response to rising investor demand, however, managers have introduced alternatives packaged in structures like mutual funds, liquid alternative funds, closed-end funds and business development companies.