Given the high degree of uncertainty in today’s global economy and financial markets, astute investors the world over are asking the question, “Are there investments I should be considering that can work in almost any market conditions? Do I have to be 100% correct on major economic forces such as inflation vs. deflation, or are there (to the extent possible) investments that can be considered all weather?”
Alternative investing provides a unique edge in comparison with traditional long-only investing. There are certain attributes which are associated with specific alternative investments that are designed to potentially perform in a wide range of market conditions. These attributes are expressed in three specific strategies which we believe are essential for an all weather portfolio.
The Investor Challenge
According to Modern Portfolio Theory (MPT), “markets are efficient” and “investors are rational.” But past crisis periods, including the recent Credit Crisis, demonstrated that theory alone was insufficient to protect investors on the downside.
Modern Portfolio Theory assumes a normal distribution of returns from the market, yet we have learned that periods of volatile or extreme returns have occurred with greater frequency than a normal distribution would predict. These “fat tails” of abnormal events are not accounted for by MPT. Additionally, MPT relies solely on historical inputs. While history is important, it does not predict the future.
During times of duress, as experienced during the Credit Crisis, traditional asset classes often become more highly correlated with one another compared to their historical relationships. As a result, many investors may be “falsely” diversified because they have relied on past correlations when building their portfolios. When the Credit Crisis hit, most traditional asset classes fell in unison because they shared a common characteristic of reliance on credit availability.
The desire to allocate to strategies that have the potential to perform well in a wide range of market conditions leads many investors to alternative investments. There are two components to a portfolio’s performance: 1) beta, or general market returns and 2) alpha, excess return (positive or negative) compared to the market, often referred to as manager skill. As investors deploy capital into low-fee, passive ETFs/Index funds to gain beta exposure, many turn to alternatives seeking alpha and to complement other portfolio holdings. Alternative investment managers may offer unique management skills and flexibility that have a potential alpha-generating advantage.
How have alternatives performed in crisis periods? When equity markets fell nearly 40% during the year 2008, the universe of hedge funds (as measured by the HFRI Hedge Fund Index) fell roughly half the distance of overall equities, providing a degree of capital preservation for the asset class as a whole. Strategies which incorporated hedging techniques demonstrated a greater potential for managing risk.
Other alternative asset classes also provided a counterbalance to this decline. During the same crisis period, managed futures (as measured by the Altegris 40 Index) demonstrated the potential benefits of non-correlated diversification, increasing by over 15 % during 2008.