Do Liquid Alternatives Help A Portfolio’s Risk Adjusted Return?

Posted on August 14, 2018 by Gemmer Asset

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I won’t beat around the bush, the answer to this question is, like many things, nuanced. It really depends on the alternative fund/vehicle you use. Obviously with hindsight we can pick the best fund, but its another story when you’re trying to make a judgement about whether or not an alternative fund will be additive to your portfolio ex-ante.

 

Morningstar came out with an interesting paper on this topic. In it, Jason Kephart attempts to asses whether alternative funds in existence since 2012 have improved a 60/40 model portfolio’s risk-adjusted return. The results of the analysis can be summed up in the below chart.

 

 

A huge majority of funds failed to improve the model portfolio’s Sharpe Ratio over the past five year period (and these numbers undoubtedly benefit from survivorship bias). Why is this the case? Well it may have something to do with rising correlations between alternative strategies and traditional stock/bond allocations.

 

 

Lower correlation between assets provides a diversification benefit – reducing volatility. Lower volatility while holding returns constant leads to higher risk-adjusted returns (Sharpe Ratio). Higher correlations reduce these positive diversification effects.

 

This article is basically saying that its been very hard to justify having a meaningful chunk of alternatives in a diversified portfolio over the last 5 years.

 

Now if you also consider the high fees of most alternative strategies, the case for alternatives becomes even tougher to make.

 

 

The fees for these strategies have also been on the rise while funds fees among traditional asset classes have been falling…

 

 

Bottom line, adding a slice of liquid alternatives now is an implicit bet that the trends of the last five years will be different over the next five. While an investor might want to make that bet, you also must have a view of how they will be different in order to make a rational fund choice. If an allocation to alternatives is something you think you need, a significant amount of due diligence is needed to try and find both the strategy and specific fund that will be additive to your portfolio’s risk-adjusted return profile – a job that is difficult given the short track record of many alternative strategies.

 

 

 

 

 

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