For years, conscientious strategists have indicated skepticism over the place for alternative investments in the context of strategic portfolio construction. For instance, Richard Bernstein penned a piece titled “An Alternative to Alternatives” as far back as May 2012. Bernstein argued that during the 1980s and 1990s fixed income returns (in particular, that of long-term Treasury bonds) were strongly correlated to S&P 500 returns. Such an environment was ripe for the rise of a purported diversifying asset class. Bernstein though goes on to demonstrate that correlations between stocks and bonds began to break down as the technology bubble burst at around the turn of the century. The chart below, excerpted from Bernstein’s note, illustrates the path of stock and bond correlations over the 31 year period between 1981 and 2012.
The point of Bernstein’s report is that reduced correlations imply that plain vanilla Treasuries now exhibit properties adequate to provide as much of a diversification benefit as does alternatives. If true, and given the hefty fees that often coincide with alternative investments, it is hard to argue in favor of their inclusion in strategic equity portfolios.
In contrast to Bernstein’s thinking though, we have come across evidence from at least one major wirehouse of the efficacy of alternatives in strategic portfolios. The case from these strategists hinges on a longer view of the comparison between the risk/reward character of portfolios with and without alternatives. To support their thinking, these pundits submit a chart featuring efficient frontiers for two sets of portfolios–one including and the other excluding alternatives. Based on a data set that spans 1990-2015, they find the frontier for the portfolios with alts sits higher than the pure stock and bond mix. As such, these strategists conclude there is value to adding alternatives.
Aside from conflating two timeframes of potentially distinctly different character, the wirehouse view made several assumptions that differed from Bernstein’s. The sell-side note proxied fixed income performance using the Barclays U.S. Aggregate Index rather than Bernstein’s choice of the BofA Merrill Lynch 15+ Year Treasury Index. Also, while Bernstein used the HFRI Fund Weighted Composite Index to represent alternatives, the big broker opted for a composite of 1/6 Absolute Return, 1/6 Equity Hedge, 1/3 Private Equity and 1/3 Real Estate.
We replicated this work in an effort to reconcile the diametric differences in perspective. We found that the wirehouse report is indeed correct–from the 90s to the present, alternative investments (as they defined the term) did add value. Specifically, the inclusion of alternatives meaningfully enhanced potential returns with equal levels of volatility in nine of ten hypothetical stock and bond portfolios examined.
However, we also concluded that Bernstein was right, as for more than the last decade, the benefit of adding alternatives to a diversified stock and bond portfolio has not been statistically significantly different than zero. This finding is illustrated in our final graphic by the extremely close proximity of the efficient frontiers for the stock and bond only and the stock, bond and alts portfolio mixes. At most points, the two curves are virtually indistinguishable.
Thus, as long as stock and bond correlations are relatively low, we are disinclined to build alternatives allocations into our strategic portfolio construction efforts. With that said though, we are not against alternatives outright. In fact, we have in the past–with good result–recommended specific deals to qualified investors that we believe have merit (generally in the private equity arena). This practice may continue (we liken this nuanced approach to being optimistic about a particular stock when the broad market is overvalued).