Talk about diversification comes cheap. Actually diversifying one's portfolio is far more difficult.
We have been preaching for some time that in an era where both stocks and bonds may be expensive, investors may want to embrace alternative investments. I have been quoted saying that unless investors have at least 20% in alternative investments, they may not be truly diversified. While that quote made some headlines at the time, many college endowments have a far greater allocation to alternatives, at times more than half of their portfolio. There may be a good reason for that; let me elaborate and make a case why, in this context, investors may want to consider absolute return investing.
Goal of Diversification
Diversification is at times described as the one free lunch Wall Street has to offer: by adding a return stream with low correlation to other investments, risk-adjusted returns might be enhanced. While it's theoretically possible to enhance risk-adjusted return with an asset that has negative returns, I have yet to meet investors embracing an investment with expected negative returns merely for its correlation attributes.
Not all alternatives are created equal. The simplest alternative investment may be gold. Maybe because it's ‘merely' an unproductive shiny metal, our analysis has shown that it historically has exhibited a very low correlation to equities and, as such, warrants evaluation as a good diversifier. The volatility in the price of gold tends to be closer to be that of equities (at times lower; at times higher). Yet gold may be the least volatile commodity; we believe that's because of the comparatively low industrial use, making its dynamics less complex.
When we say investors may want to have a substantial portion of their assets in alternatives, much of that assumes that alternatives exhibit low volatility and, as such, a large allocation may be necessary to counter the swings of volatile equity positions. When it comes to commodities, their volatility can be rather high; as such, investors may be well served to justify a higher than usual gold or commodity allocation for reasons other than volatility.
Whereas volatility in commodities may be obvious, there may a lot of what one might call latent volatility in other investments. In today's environment, this may apply to stocks and bonds as much as to alternatives. That's because we believe central banks have ‘compressed risk premia', i.e. taken perceived risk out of the market. Markets are, of course, still risky, but you wouldn't know it if you look at what has been generally low volatility in stocks and bonds in recent years. When volatility does flare up, it can come back with a vengeance, as we have sporadically seen. In this context, we have referred to ‘taper tantrums' akin to the Fed trying to gently take the lid off a pressure cooker, which - surprise, surprise, doesn't work so well.
But latent volatility can also lurk in alternatives. Remember those emerging market local currency bond investments that appeared to offer high returns at low volatility (partially because their currencies were tightly managed); those strategies worked until, well, they didn't anymore because emerging markets may ultimately be proxies for liquidity; and when there's fear in the market, liquidity can vanish.
Or take investments in master limited partnerships; in a quest for income, such ‘alternatives' had been embraced by many investors. That is, until the price of oil started to plunge and it became apparent just why those investments had yielded so much in the first place: they were risky…
Bubble, bubble, bubble?
Looking at the bond market these days, I have flashbacks to the dot com bubble of the late 1990s. It was December 5, 1996, that former Fed Chair Alan Greenspan gave his speech warning about ‘irrational exuberance', yet it took the equity markets until 2000 to peak. What may have appeared to be sky high valuations became ever-higher valuations.
Similarly, while many of us have been scratching our heads about low to negative sovereign bond yields, we see ever more stunning bond prices, with both 50 year Swiss government bonds and 20 year Japanese government bonds now yielding negatively, i.e. investors paying governments to take their cash. Something within us can give a rationale explanation; another part of us says this is plain nuts. Years from now, with hindsight, it will be obvious.