Alternatives: the benefits of non-correlated alpha
In 2022, 60/40 portfolios suffered as both stocks and bonds sold off and the power of bonds as a diversifier—and, accordingly, a means of helping to reduce portfolio volatility—deteriorated. Meanwhile, record inflation served to exacerbate the issue and erode real returns. These challenges indicate an increased need for alternatives that offer both diversification to equities and bonds as well as compelling long-term return potential.
In 2022, investors faced several key challenges.
1 Diminishing returns of a 60/40 portfolio
Both equities and bonds suffered drawdowns in 2022. While the trajectory for equities is marked with uncertainty, bond return potential diminished as historically low yields translated to lower coupon payments, negative real yields, and less scope for price appreciation.
Global bonds recorded worst drawdown on record in 2022, with little yield cushion to soften the blow
Bloomberg Global Aggregate Index, 1/31/90–10/31/22 (%)
Source: Bloomberg and Graham Capital Management, L.P., 10/31/22. The Bloomberg U.S. Aggregate Bond Index tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets.
2 Positive stock/bond correlation
Equity/bond relationships are not static, and there have been extended periods of positive stock/bond correlation. In our view, historically low yields mean that the protective character of bonds is in jeopardy and investors may increasingly see positive correlations between stocks and bonds.
Correlations between S&P 500 Index and U.S. 10-year Treasury bonds
100 years ending 10/31/22, 5-year rolling window
Source: Robert Shiller Database, 10/31/22.
3 Volatility and market uncertainty
Given geopolitical developments and macro imbalances, markets have exhibited heightened volatility in recent months alongside an increased potential for market shocks. We believe that should the equity hedging benefit of bonds continue to diminish, as it has in 2022, the ability to manage portfolio volatility will become more challenging.
4 Inflation sensitivity
CPI reached a 40-year high of 9.1% in June 2022. Elevated inflation presents a significant risk to stock/bond portfolios in terms of asset valuation, erosion of real returns, and positive correlation. When inflation rises, real yields decline alongside the market price of bonds. Inflation can also weigh on stocks when combined with hawkish monetary policy, as we saw in the 1970s, potentially leading to simultaneous losses in stocks and bonds and positive correlations.
Stock/bond correlation has increased with inflation
E-mini S&P 500 Index futures, U.S. 10-year Treasury bond futures, 4/30/84–10/31/22
Source: Bloomberg and Graham Capital Management, L.P., 10/31/22. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The Consumer Price Index (CPI) tracks the average change of prices over time by urban consumers for a market basket of goods and services. U.S. Treasury bond futures are standardized contracts on U.S. government notes or bonds. It is not possible to invest directly in an index.
The role of alternatives
1. Enhance returns
Ideally, investors should seek alternative strategies with positive long-term return potential and low correlation characteristics, which offer the potential to enhance the risk-adjusted returns of a broader investment portfolio.
2. Provide diversification
Many alternatives have low correlation to stocks and bonds, with the ability to profit in both rising and falling markets with no inherent bias and the potential to provide equity crisis returns.
3. Reduce volatility
Diversification properties result in the potential to reduce the overall volatility and drawdowns of a broader investment portfolio. Active risk management approaches can help navigate market volatility and changing market dynamics.
4. Inflation agnostic
Many alternatives may perform well in inflationary or noninflationary regimes and may capitalize on increasing commodity prices during inflationary periods.
Where can investors turn to for diversification? Not all alternatives are created equal
Many investors seek diversification through alternative strategies. However, not all alternatives provide the desired portfolio diversification benefits. Diversification benefits vary significantly across styles, and many strategies have positive correlation during equity down markets.
Correlation of alternatives to equities
Source: eVestment and Graham Capital Management, L.P., 10/31/22. Data is presented from HFRI index inception in January 1990 with the exception of the credit and trend following indexes, which are available from January 2008. Equities are represented by MSCI World Index, which tracks the performance of publicly traded large- and mid-cap stocks of developed market companies. Trend following is represented by the HFRI Institutional Trend Following Directional Index, a global, equal-weighted index of single-manager funds that employ macro trend-following. Macro strategies are represented by the HFRI Macro Index, which involves investing by making leveraged bets on anticipated price movements of stock markets, interest rates, foreign exchange, and physical commodities. Relative value is represented by the HFRI Relative Value Index, which maintains positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Emerging markets is represented by the HFRI Emerging Markets (EM) (Total) Index, a global index of securities or the sovereign debt of developing or emerging countries. Event driven is represented by the HFRI Event Driven Directional Index, a global, equal-weighted index of single-manager funds that are classified as special situations, credit arbitrage, and distressed funds. Credit is represented by the HFRI Credit Index, which is a composite index of strategies trading primarily in credit markets. Equity hedge is represented by the HFRI Equity Hedge Index, which tracks multistrategy investment managers who maintain long and short positions of no more than 50% in primarily equity and equity-derivative securities. Hedge fund composite is the HFRI Fund Weighted Composite Index, a global, equal-weighted index of single-manager funds that report to HFR Database monthly net of all fees performance in U.S. dollars. It is not possible to invest directly in an index.
In 2022, markets experienced a trifecta of a sell-off in equity and bond markets, heightened market volatility, and elevated inflation, making it a difficult year for many investors. From an asset allocation perspective, investors should consider allocations to alternative strategies that, ideally, have positive long-term return potential and diversifying characteristics during difficult equity environments. Notably, diversification should be a constant rather than a reaction to short-term market conditions.
2022 major market moves and performance of alternative strategies
Source: Bloomberg, HFRI, and Graham Capital Management, L.P., 10/31/22. Alternative strategies are represented by their respective HFRI indexes. For purposes of this presentation, we show broad hedge fund indexes as categorized by HFRI, but our selection is not meant to be an exhaustive representation of all potential alternatives. Other investment strategies, including private equity, real estate, and venture capital, among others, are often considered to be diversifiers to traditional stock and bond portfolios but are not shown here due to limitations on the availability of a representative index or other constraints or considerations.
Market conditions continually change, and one of the best ways to construct a portfolio resilient to changing market regimes is through proper diversification. We believe allocating to strategies that have low correlation to equities and bonds can be a valuable portfolio construction tool with the potential to lower the volatility and soften the drawdowns of an overall portfolio while adding to returns over the long run. These strategies are meant to complement—rather than compete with—traditional investments. And while it is unreasonable to expect any strategy to perform well at every discrete point in time, holding diversifying alternatives as a long-term, strategic allocation in a diversified investment portfolio offers the potential for significant benefits.
Below, we show the impact of allocating to macro and trend-following strategies, which are widely regarded as effective diversifiers within an investment portfolio.
Potential benefits of allocating to macro and trend
Source: eVestment and Graham Capital Management, L.P., 10/31/22. Since inception of HFRI Macro Index, January 1990 to October 2022.
The bottom line
- In the current investment landscape, there is a need for alternatives that can offer both positive return potential and diversification to both equities and bonds.
- Diversifying strategies such as macro and trend following may offer significant long-term return and diversification benefits, with the flexibility to capture moves across a variety of market environments.
- Allocating to diversifying strategies as a strategic, long-term investment within a diversified portfolio may potentially enhance risk-adjusted returns and help reduce overall volatility and drawdowns.
Portfolios that have a greater percentage of alternatives may have greater risks. Diversification does not guarantee a profit or eliminate the risk of a loss. Past performance does not guarantee future results.
Alternative investments by their nature involve a substantial degree of risk, including the risk of total loss of an investor's capital. Further, alternative investments are subject to less regulation than other types of pooled investment vehicles, may be illiquid, and cannot assume that investments in the asset classes identified will be profitable or that decisions we make in the future will be profitable. Alternative investments may also involve significant use of leverage, making them substantially riskier than other investments.
The views expressed are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index.
Investing involves risks, including the potential loss of principal. A portfolio concentrated in one sector or that holds a limited number of securities may fluctuate more than a diversified portfolio.