The Hidden Allure of Alternatives Investments

Many investors question the value of alternative-investment funds given their relatively low returns versus those of traditional equity and bond mutual funds.

In Table 1, we show the current three-year cumulative returns, risk (measured by standard deviation) and correlation to the S&P 500 for alternative classifications for the period that ended on Nov. 30, 2013.

The S&P 500 SPDR ETF earned 62.8% during the same three-year period. As for its risk, its standard deviation was 12.4. All of the alternatives funds underperformed the S&P 500 on a return basis, but all of them were less risky than the S&P 500. Finally, six of the 10 classifications have a significant correlation to the S&P 500.

Table 1 would seem to make the case that adding most alternatives to one's holdings makes, at best, limited sense if an investor is looking for return. And if an investor is looking for low correlation, a reason often given for investing in alternatives, only four of the classifications seem to fit the bill.

To reduce downside risk and increase diversification, you're better off adding bond funds or possibly real estate funds, both of which offer low correlation to equity investments.

But judging the value of alternatives by using the S&P 500 can be deceiving. Consider the "portfolio" in Table 2 and its performance during the Great Recession.

This portfolio looks like a well-diversified portfolio in terms of exposure to different asset classes. The funds used were the iShares Dow Jones U.S. Real Estate ETF (IYR), Fidelity International Real Estate (FIREX), Barclays Aggregate Bond ETF (AGG), GSCI Commodity ETF (GSG), Vanguard Global Equity (VHGEX), and T. Rowe Price International Bond (RPIBX). Long-only funds were used as they are typical of most retail investors' mutual fund and ETF holdings.

During the credit crisis, losses for this traditionally diversified portfolio were substantial in all cases except for bond funds. Is there anything that could have been done to mitigate those losses? Look at Table 3.

With a 20% to 30% exposure to alternatives funds such as long/short funds or market-neutral funds, the portfolio's losses would have been significantly reduced and its volatility improved. Why? If an alternatives' correlation is computed against a benchmark composed of all the holdings in a portfolio (which is the true benchmark), alternatives funds like long/short funds and market-neutral funds have a low correlation.

This means two things: (1) chances are the alternatives fund will not pay out as much as the portfolio in good times, and (2) the shareholder will be able to "sell away" some of the portfolio's exposure (in particular, downside risk exposure) to general market movements. It is the latter, the selling away of risk, that is the primary benefit of using alternative funds.

So, are alternatives worth having? It seems the answer is yes when markets move against a portfolio. But what happens as the markets recover?

Table 4 shows the performance of the same portfolio in Table 2 for the period from October 2007 through September 2013. And Table 5 shows the performance if the investor continued to hold on to the alternatives purchased in October 2007.

When comparing Table 5 with Table 4, notice how in each case, with the exception once again of bonds, returns improve and risk is reduced. How can this be, since Table 1 shows the poor return performance of alternatives over the last three years? The answer is simple: The alternative-investment portfolio reduced losses during the Great Recession, so as the markets improved, the portfolio performed better. To state it another way, the alternatives portfolio had a smaller loss during the Great Recession-in some categories, much smaller. When the market turned around, the alternatives portfolio recovered its losses faster than the non-alternatives portfolio, since it started from a less negative base.

This, in short, is the benefit of using alternatives as a way to protect a retail investor's long-only asset holdings. Our look at the 30% investment level shows a significant improvement in returns and risk-adjusted measures, especially during the recent credit crisis.

So, do not be put off by the low returns of alternatives. Consider the amount of risk, especially downside risk, you want to have. If you want to sell off a significant amount of downside risk, advisors (and academic research) recommend a 20% to 30% exposure. For investors who want to reduce risk to a moderate extent, a 15% to 20% exposure would probably be beneficial.

Andrew Clark is manager of Alternative Investment Research at Lipper.