The New Diversification: Adding Alternatives

According to Mark Peterson, director of investment education at BlackRock, speaking for a webinar hosted by Envestnet, traditional diversification vehicles underperformed when the return environment changed. Traditional stocks and bonds worked well until the 2000s. While bonds have done well since, equities have been volatile. And, now bonds will become a challenge with rising interest rates.

Peterson adds that for equity investments, correlations (the tendency for investment vehicles to move similarly in the market) have been increasing over time. Equities, including international and emerging markets, tend to cluster in the same return neighborhood with increased correlation; all equities fell during the financial crisis.

How to Diversify Better

Risk is more than just about volatility, and alternative investments can help mitigate the different risk factors, Peterson contends.

“In a higher inflation world, floating rate or bank loan funds are a tremendous inflation hedge,” Peterson said. “Commodities are second best, and inflation-protected bonds, high-yield municipal bonds, natural resources investments, and energy investments all correlate well in higher inflation environments.”

For interest rate risk, Peterson suggests, investors consider floating rate loans or high-yield bonds. For currency risk, use global or currency investments or commodities.

“Adding alternatives widens out clustering; you get all types of returns in a bear market,” he adds.

Adding Alternatives

Peterson explains there is no standard definition of an alternative investment. “They are simply ‘alternatives’ to traditional debt and equity.” BlackRock thinks of alternative investing on two levels: via asset classes, such as commodities, currency, direct real estate, direct infrastructure, real assets and renewable energy; and via strategies—for equities, long, short or private, and for bonds, arbitrage or distressed.

Instead of just having alternative investments included in an “other” piece in a portfolio, plan sponsors should have an “alternatives” piece for different alternative asset classes, and they should split the strategies for traditional asset classes between traditional strategies and alternative strategies, Peterson suggests. He says the alternatives portion of the portfolio should be in the 15% to 20% range to make a difference, noting that adding alternatives in the last 12 to 15 years would have lowered risk and improved returns.

Manager skill is vital when selecting alternative investments and strategies—in 2012, the return difference between top and bottom managers was 13.50% versus -3.34%, Peterson says. Plan sponsors need alternatives managers with a lot of experience that can execute strategies well. Plan sponsors may spend more on due diligence when looking for the right manager, but it will pay off, he adds.

According to Peterson, the most common mistake investors make when adding alternatives to a portfolio is with the source of assets to invest. “After the financial crisis, folks were sourcing their entire alternatives allocation from equities, since equities did poorly, but equities were a buy at the bottom of market, buying alternatives at that time only reduced risk, it didn’t boost returns,” he notes. Plan sponsors should make sure their investment sourcing matches what they’re trying to do—to just reduce risk or both reduce risk and increase returns. “They may be trying to reduce risk in fixed income and boost returns for equities.”