Wednesday, May 22, 2013
Alternative Investments: Implementation Solutions By Sam Masemer, CFA, CFP® and Alyssa Ballin, CFS
The Alternative Investment Value Proposition
Heightened volatility and increased correlations1 across equity markets have investors searching for non-traditional methods to enhance diversification within asset allocation models. Historically, alternative investments2 have satisfied this enhanced diversification desire, but were only available to wealthy individuals and institutions. Today, alternative investments are available in a traditional mutual fund format for all investors. So how does an investor transition from a highly correlated portfolio to one that is well-diversified by allocating to alternative investments? One approach would be to study the asset allocation models of endowments.
Endowments and Alternative Investments
Endowments have utilized alternative investments for diversification purposes for decades. In fact, the percentage by which they have allocated assets to alternative investments has recently spiked.
Figure 13 illustrates how endowments dramatically increased their allocation to alternative investments from 2007 to 2011. The primary funding vehicle utilized to increase the allocation to alternative investments was the equity portfolio. During this three-year period, the percentage of total allocation to alternative investments increased by 20% while equities decreased by 19%. These allocation trade-offs were made in response to the rising correlations of traditional equity asset classes, which spurred endowments’ efforts to pursue greater diversification within their asset allocation models.
|“The allocation shift from equities to alternative investments by endowments appears to coincide with rising equity correlations.”|
Diversification Increasingly Difficult to Attain
Approximately a decade ago, a modicum of diversification was achieved by investing across domestic equity market capitalizations, foreign equities, and fixed income.
Figure 24 demonstrates how investors’ ability to achieve diversification in the equity portion of an allocation has clearly changed, as the correlations of all domestic equity market capitalizations and foreign equities have increased significantly versus large cap domestic equities. The allocation shift from equities to alternative investments by endowments appears to coincide with rising equity correlations.
|“...investing in lower market capitalizations no longer achieves the same level of diversification. The residual effect is primarily increased volatility.”|
Are High Equity Correlations Here To Stay?
It is difficult to believe there could be a meaningful decrease in correlations in the near term. It is our observation that one of the main causes of rising correlations in equities is the proliferation of exchange traded fund (ETF) assets. There appears to be a causal effect between increasing assets under management of U.S. ETFs and rising correlations across equity market capitalizations.
Figure 35 illustrates the explosive increase in the growth rate of ETFs. ETF assets under management are expected to grow by 15.8% annually through 20156, which leads us to conclude that high equity correlations could be here to stay.
|“By redistributing a portion of the equity allocation to alternative investments, investors could improve their portfolio diversification while potentially creating a smoother return stream.”|
How Can Investors Increase Their Allocation to Alternative Investments?
Pairing asset classes and investments that are lowly correlated can potentially reduce portfolio volatility. We have demonstrated how endowments have decreased their exposure to equities by redistributing these assets to alternative investments.
An individual investor contemplating this same course of action must determine what equity risk profile is appropriate to achieve their goals and if they are comfortable with the associated risk. Figure 47 illustrates the volatility (represented by rolling five-year beta8) of major equity asset classes as compared to the large-cap domestic equity asset class. The graph illustrates how the highly correlated domestic equity sleeve becomes more volatile as market capitalizations decrease. Therefore, assuming that most investors have an allocation to large-cap equities, investing in lower market capitalizations no longer achieves the same level of diversification. The residual effect is primarily increased volatility.
|“Pairing asset classes and investments that are lowly correlated can potentially reduce porfolio volatility.”|
One cannot invest directly in an index. Diversification does not assure a profit or protect against loss in a declining market. Alternative investments may result in additional risk due to their complexity and possible illiquidity and require specialized investment expertise. Investments in smaller companies involve additional risk such as limited liquidity and greater volatility than larger companies.
1 Correlation is a statistical measure of how two securities move in relation to each other as measured by the correlation coefficient, a statistic that ranges in value from -1 to +1, indicating a perfect negative correlation at -1, absence of correlation at zero, and perfect positive correlation at +1.
2 Alternative Investments are those that fall outside the traditional asset classes of stocks, bonds and cash.
3 Asset Allocations by Endowments With Assets Greater Than $1B from 2007 to 2011. Source: National Association of College and University Business Officers.
4 Correlation from 1996 to 2011 (60-Month Moving Windows, Computed Yearly). Source: Zephyr StyleADVISOR®.
5 Growth of U.S. ETFs from 2000 to 2011. Source: alletf.com, Powered by Dorsey Wright 7/14/2011 - derived from the National Stock Exchange.
6 Source: BNY Mellon and Strategic Insight, 2010: ETFs 2.0 The Next Wave of Growth and Opportunity in the U.S. ETF Market, p. 16.
7 Beta from 2003 to 2011 (60-Month Moving Windows, Computed Yearly). Source: Zephyr StyleADVISOR®.
8 Beta measures the variance of a security or portfolio, or its volatility, compared to that of the market as a whole.