Portfolio Allocations for New Market Conditions

The use of alternative strategies can help investors ride the wave and minimize losses in the long term.

We’re in the midst of a stock market plagued by uncertainty. Global economic ties are more fragile than ever, manipulated global interest rates have dimmed yields, and a once seven-year charging bull market has slowed to a crawl since the ring of the New Year.

Investors with traditional asset-allocation models of long-only stocks and bonds are no longer adequately positioned for risks and opportunities. The traditional 60/40 (60 percent in equities, 40 percent in bonds) may not be so steadfast today, but it remains rooted in the time-old premise: Equities drive growth, and bonds (or similar assets) provide more consistent, risk-averse returns.

The business case for shifting portfolio allocation

But in the current landscape — where interest rates are very low and the equity market is experiencing high volatility — neither of those approaches work. Instead, a small fundamental shift in portfolio allocation can provide security when volatility is high. Allocating 20 percent of a portfolio to alternatives,

Allocating a portion to alternatives will stabilize high volatility.

with the remaining 50 in equities and 30 in bonds, provides a buoy for the overall portfolio.

This allocation model has historically demonstrated stronger performance during periods of significant stock-market declines, compared to the traditional 60/40. There are a few reasons for this.

First, a weight in alternative strategies exposes a portfolio to assets uncorrelated to the equity and bond markets. Where the traditional allocation utilizes stocks and bonds as each other’s safeguard, a 20-percent allocation to alternatives alleviates that strong dependency.

Because of the non-traditional investments that these alternative strategies employ, investors have the potential to generate new and uncorrelated sources of returns. This is perhaps most important in today’s market, where traditional sources of alpha are minimized. With so much uncertainty, fundamental analysis can be less reliable. Alternative strategies often generate returns from unique sources, allowing investors to circumvent the sometimes unreliability of traditional analysis.

Second, alternatives have delivered higher returns than stocks and bonds, with less than half of the volatility of stocks over the last 20 years. Figure 1 and Figure 2 detail these data. Reducing volatility exposure can prove particularly beneficial in the current market landscape.

Where bonds were once a steadfast resource of low volatility, the manipulation of global interest rates has severely diminished this asset’s reliability. Allocating a portion to alternatives will stabilize high volatility, particularly those strategies that each seek to offer uncorrelated streams of returns and diversified risk exposures.

Using alternative strategies

Alternative strategies tend to be perceived as complicated in nature, deterring some investors from diving head first into this sector. But even incremental investments in this sector can still prove beneficial. A five percent portfolio allocation to alternatives would have historically resulted in a portfolio with higher annualized returns and lower volatility, as Figure 3 displays. For investors hesitant to allocate a larger portion of their investments in this sector, an allocation as small as five percent would have historically proved a beneficial investment.

Market volatility shows no signs of easing, and investors must prepare their portfolios accordingly. In current market conditions, relying on equities and bonds alone can prove detrimental. In allocating a portion of a portfolio to alternative strategies, uncorrelated to traditional markets, investors can better position themselves to ride the wave and minimize losses in the long term.

By Robert Faingold