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Alternatives to strengthen a portfolio

Alternatives to strengthen a portfolio

05 February 2021

Gerald Moser, Zurich Switzerland, Chief Investment Strategist

 

With many asset valuations seemingly expensive and rates likely to remain low, it may be time to diversify traditional holdings with alternatives.

Diversifying away from 60-40

From a portfolio perspective, balancing the returns’ objective with the risks’ constraints is key to be positioned appropriately.

In several recent articles, we discussed the fading power of a traditional 60-40 portfolio (or 60% invested in equities and 40% in government bonds). While that combination offered powerful diversification for many decades, a few developments in recent years have hindered its effectiveness.

Low interest rates, central banks’ focus on growth and stretched valuations have respectively hit income prospects for government bonds, tightened correlations with equities and lowered likely capital appreciation for fixed income. An unwelcome cocktail of factors for those using the allocation strategy to weather financial market downturns.

And while we do not expect a bear market in the near term, diversification can be handy during a correction. Indeed, every bear market starts as a correction but underlying imbalances then push the correction into a much longer period of underperformance for growth-sensitive assets. For this reason, while looking at corrections in retrospect is easy, it is important to remember that being invested during a correction can feel uneasy. This is why any properly diversified portfolio should be built to weather any sort of volatile events.

Corrections are typical in a bull market

It is typical to see on average a 10% correction every year during a bull market

Considering the strong performance of global equities in recent months – up around 20% since early November – a correction seems likely in coming months. In fact, it is typical to see on average a 10% correction every year during a bull market.

Considering the stage in the recovery, this has often been a period during which markets’ sentiment often wavers. After the worst period has been weathered, markets initially rebound strongly. But once the initial relief is over, markets can become more jittery until the overall direction is clearer.

Learning from previous sell-off recoveries

Taking a look at the 2003-2004 and 2009-2010 periods, two recent episodes when the S&P 500 recovered from a large sell-off, in both instances markets troughed in March of the first year before significantly rebounding for around 12 months. In 2003, equities rallied 45% before experiencing a correction in February 2004. In 2009, the markets rose 70% before selling off in January 2010. In comparison to those two episodes, the S&P 500 has climbed by around 70% since troughing in March.

In both 2004 and 2010, equities experienced not one, but two corrections of around 7% during the year. But overall, the S&P 500 finished up 9% and 13% respectively in those years. Indeed, all corrections were short-lived, only lasting between one and three months. And markets recovered from the losses equally rapidly. Those corrections offered little, if any, opportunity to enter markets as they were short-lived.

Overall, dissecting all bull-market corrections (excluding those which turned into a bear-market) in US equity markets since 2000, the average correction lasts 1.5 months and the market recovers in less than three months from reaching the bottom (see table). The velocity and violence of those turns probably makes it futile to try and time them and it seems preferable to stay invested throughout while diversifying portfolios in assets which offer relative outperformance during those periods.

Anatomy of US equity corrections since 2000

  Length in correction (months) Length in recovery (months) S&P 500 Gold HFRI Equity markets neutral
Average 3.5 6.9 -14.5% 3.0% 0.1%
Average (ex bear markets) 1.5 2.6 -10.8% 0.7% -0.2%
Median 1.4 2.8 -9.2% 1.0% 0.0%
                    Average rolling annual performance (2000 - 2020) 5.5% 10.9% 3.1%
Average rolling standard deviation (2000 - 2020) 16.2% 16.3% 3.8%

Source: Bloomberg, Barclays Private Bank

Alternatives for diversification

Hedge funds, gold and private markets are all alternatives asset classes that should be part of diversified, “all-weather” portfolios. The table looks at the performance of alternative assets, such as gold and several hedge fund strategies, which in theory should not be correlated with equities when the latter is selling off.

The data suggests that the three alternatives are good diversifiers when it is most needed, such as during sharp downturns. On average, gold returns are slightly positive during corrections while those from market neutral hedge funds tend to be flat. However, this is against a backdrop of equities losing more than 10% on average.

At the same time, it is worth noticing that gold, hedge funds and private market assets offer positive returns on average through the cycle. The average rolling annual performance of gold since 2000 is 11% while a market neutral hedge fund’s benchmark delivers 3%.

Coming to the rescue

Government bonds are providing little, if any, income for investors, indeed offering negative cash flow in much of Europe. As such, there are likely to be opportunities to improve the risk/return profile on a portfolio through the cycle by adding alternatives.

Gold, hedge fund strategies with low beta (like market neutral, macro multi-strategy or low net equity long-short) and private markets are a case in point. With a special focus on managers’ selection when it comes to private markets and hedge funds, those alternatives strategies can offer a much needed asymmetric risk/return profile to a portfolio.