Why Alternatives?

The financial markets exist in a constant state of flux. For every bull market period, there is a bear market period. But whether the markets are having good times or not so good times, investors' core goals and advisors' main tasks stay the same:

  • Preserve wealth by avoiding losses
  • Build wealth to pay for a comfortable retirement, their children's college education or a dream vacation, for example
  • Generate sufficient income throughout retirement to support their lifestyle

Certain alternatives, such as commodities, may help investors hedge their portfolios against inflation. As seen in the chart below, the commodities index became available in 1973, in the midst of the 1966-1981 inflation period. In the nine years after the index was launched, we can see that commodities outperformed inflation, and stocks and bonds did not.

Commodities have historically outpaced inflation

Time Frame
1929-1941
(13 Years)
1942-1965
(24 Years)
1966-1981
(16 Years)1
1973-1981
(9 Years)1
1982-1999
(18 Years)
2000-2014
(15 Years)
Market Environment
Deflation Low-
Inflationary Growth
Inflation Inflation Low-
Inflationary Growth
Deflation-Like*
Corporate Bonds
6.06
Stocks
15.70
Inflation
7.00
Commodities
12.81
Stocks
18.52
Long-term Gov't Bonds
8.42
Long-Term Gov't Bonds
4.55
Inflation
3.06
T-bills
6.83
Inflation
9.22
Corporate Bonds
12.17
Corporate Bonds
8.38
T-bills
0.79
Corporate Bonds
2.45
Stocks
5.95
T-bills
8.23
Long-Term Gov't Bonds
12.08
Stocks
4.24
Inflation
-0.79
Long-Term Gov't Bonds
2.11
Corporate Bonds
2.89
Stocks
5.16
Commodities
9.00
Inflation
2.30
Stocks
-2.43
T-bills
1.70
Long-Term Gov't Bonds
2.53
Corporate Bonds
2.49
T-bills
6.23
T-bills
1.85
Commodities
N/A
Commodities
N/A
Commodities
N/A
Long-Term Gov't Bonds
2.49
Inflation
3.29
Commodities
1.04

* This period did not represent a true deflationary period because consumer prices did not fall. However, the reductions in credit supply that occurred in the early and later part of the decade led to economic contractions similar to what would be experienced in a deflationary environment.
Sources: Morningstar, Bloomberg L.P., Lipper (commodities) as of Dec. 31, 2014. Stocks are represented by the S&P 500 Index; inflation by the Consumer Price Index; commodities by the S&P GSCI Index; long-term government bonds by the Ibbotson U.S. Long-Term Government Bond Index; T-Bills by the Ibbotson U.S. 30-Day T-Bill Index; and corporate bonds by the Ibbotson U.S. Long-Term Corporate Bond Index. Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds. An investment cannot be made directly in an index. Past performance is not a guarantee of comparable future results.
Diversification does not guarantee a profit or eliminate the risk of loss.
The above table is presented for information purposes only and does not represent the performance of any particular investment.

Given the length of the current bull market and the low level of interest rates, many investors are concerned about the potential for both stocks and bonds to decline simultaneously. To potentially protect their portfolios, investors may explore asset classes such as market neutral, for example, which typically involves matching long and short positions in different stocks in an effort to increase the return from stock selections and decreasing the impact of broad market movements.

Market neutral strategies have performed favorably in down markets

Market neutral strategies have underperformed the S&P 500 in up markets

Source: Invesco and StyleADVISOR for the period January 1997 through December 2014.
Please note: BarclayHedge is not affiliated with Barclays Bank or any of its affiliated enitites.
Past performance is not a guarantee of future results. An investment cannot be made in an index.

To create an allocation to alternatives, investors must determine whether to direct funds away from current stock, bond or cash allocations. We believe allocating proportionately away from both stock and bond allocations is the appropriate place to start in guiding investors towards using alternatives. For example, by adding a 20% allocation to alternatives, a portfolio can increase its diversification and may be able to generate more return with less risk relative to a traditional 60% stocks/40% bonds portfolio.

Strategies for implementing alternatives in a portfolio

Source: Invesco, StyleADVISOR as of Dec. 31, 2014. Inflation-Hedging Strategies represented by FTSE NAREIT All Equity REIT Index, Dow Jones UBS Commodity Index and Alerian MLP Index. Principal Preservation Strategies represented by BarclayHedge Equity Market Neutral Index; Portfolio Diversification Strategies represented by BarclayHedge Global Macro Index, BarclayHedge Multi-Strategy Index and BarclayHedge Currency Traders Index; Equity Diversification Strategies represented by BarclayHedge Long/Short Index; and Fixed Income Diversification Strategies represented by Credit Suisse Leveraged Loan Index, HFN Fixed Income Arbitrage Index and BarclayHedge Fixed Income Arbitrage Index. Equities represented by S&P 500 Index. Fixed income represented by Barclays U.S. Aggregate Bond Index. Please note: BarclayHedge is not affiliated with Barclays Bank or any of its affiliated enitites. An investment cannot be made directly in an index. Past performance is not a guarantee of future results.

Hedge funds are typically aggressively managed portfolios of investments for high net worth investors that use advanced investment strategies such as leverage, long, short and derivative positions with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Hedge fund managers have less restriction on their investment methodologies than mutual fund managers, and hedge funds are less regulated and therefore offer less investor protection than mutual funds. Mutual funds are more transparent with regard to disclosure of underlying holdings and have lower fees than hedge funds.

For many investors, stocks are the largest part of their portfolios, making equity diversification critical.

Here, we see how one type of equity diversification strategy — long/short equities — outperformed stocks during the financial crisis of 2007 to 2009.

Long/short strategies have endured lower drawdowns than the S&P 500

Source: Invesco and StyleADVISOR for the period January 1997 through December 2014. Note long/short strategies may have experienced periods of underperformance relative to traditional equity indexes. Please note: BarclayHedge is not affiliated with Barclays Bank or any of its affiliated enitites. Past performance is not a guarantee of future results. An investment cannot be made in an index.

Hedge funds are typically aggressively managed portfolios of investments for high net worth investors that use advanced investment strategies such as leverage, long, short and derivative positions with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Hedge fund managers have less restriction on their investment methodologies than mutual fund managers, and hedge funds are less regulated and therefore offer less investor protection than mutual funds. Mutual funds are more transparent with regard to disclosure of underlying holdings and have lower fees than hedge funds.

Investors who seek to boost yield, defend against rising rates and/or generate returns different from traditional fixed income investments can explore investment options such as bank loans, unconstrained fixed income and long/short credit.

Bank loans, for example, provide a natural hedge against rising interest rates. They pay interest at a spread over a floating base rate (Libor*) which means when rates rise, income payouts on bank loans typically increase as well, unlike traditional fixed income investments. Historically, in rising rate environments bank loans have outperformed bonds.

Bank loans outperformance during rising rate environments

* London Interbank Offered Rate
Source: Federal Reserve, Lipper as of Dec. 31, 2014. Performance is cumulative and rising rates are defined as any period where rates increased at least 1%. Loan performance is represented by Credit Suisse Leveraged Loan Index and bond performance is represented by Barclays U.S. Aggregate Bond Index.
Note during declining rate environments, bank loans may have experienced periods of underperformance relative to bonds.
Unlike bonds, bank loans are secured by collateral, but are typically made to below investment-grade companies. The risk of default may be higher when compared to loans or bonds issued for investment-grade companies, but bank loans typically have a lower risk when compared to noninvestment-grade or high-yield bonds.

1 Source: Simfund. Data as of June 30, 2015.

Alerian MLP Index is a composite of the 50 most prominent energy master limited partnerships calculated by Standard & Poor's using a float-adjusted market capitalization. Barclays U.S. Aggregate Bond Index (Barclay's U.S. Agg) is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market. BarclayHedge Currency Traders Index is an equal weighted composite of commodity trading advisors' managed programs that trade currency futures and/or cash forwards in the inter-bank market. BarclayHedge Equity Long/Short Index includes hedge funds that employ a directional strategy involving equity-oriented investing on both the long and short sides of the market. BarclayHedge Equity Market Neutral Index includes hedge funds that attempt to exploit equity market inefficiencies and usually involves being simultaneously long- and short-matched equity portfolios of the same size within a country. BarclayHedge Global Macro Index includes hedge funds that carry long and short positions in any of the world's major capital or derivative markets. These positions reflect their views on overall market direction as influenced by major economic trends and or events. The portfolios of these funds can include stocks, bonds, currencies, and commodities in the form of cash or derivatives instruments. Most funds invest globally in both developed and emerging markets. Only funds that provide net returns are included in the index calculation. BarclayHedge Fixed Income Arbitrage Index includes hedge funds that aim to profit from price anomalies between related interest rate securities. Most managers trade globally with a goal of generating steady returns with low volatility. This category includes interest rate swap arbitrage, US and non-US government bond arbitrage and forward yield curve arbitrage. Only funds that provide net returns are included in the index calculation. BarclayHedge Multi-Strategy Index includes hedge funds that are characterized by their ability to dynamically allocate capital among strategies falling within several traditional hedge fund disciplines. The use of many strategies, and the ability to reallocate capital between them in response to market opportunities, means that such funds are not easily assigned to any traditional category. Only funds that provide net returns are included in the index calculation. Consumer Price Index is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living. Credit Suisse Leveraged Loan Index represents tradable, senior-secured, US-dollar-denominated, noninvestment-grade loans. Dow Jones UBS Commodity Index is designed to be a liquid and diversified benchmark for the commodity futures market. It is a rolling index composed of futures contracts on 19 physical commodities traded on US exchanges. FTSE NAREIT All Equity REIT Index is an unmanaged index considered representative of US REITs. HFN Fixed Income Arbitrage Index includes funds that attempt to exploit pricing inefficiencies between credit sensitive instruments which may include government or corporate debt, structured securities and their related derivatives. Ibbotson U.S. 30-Day T-Bill Index is measured by rolling over each month a one-bill portfolio containing, at the beginning of each month, the bill having the shortest maturity not less than one month. Ibbotson U.S. Long-Term Corporate Bond Index is a market value-weighted index which measures the performance of long-term U.S. corporate bonds. Long-term corporate bond total returns are represented by the Salomon Brothers Long-Term High-Grade Corporate Bond Index. The Index includes nearly all Aaa- and Aa -rated bonds with at least 10 years to maturity. If a bond is downgraded during a particular month, its return is included in the index for that month before removing it from future portfolios. The Ibbotson U.S. Long-Term Corporate Bond Index includes reinvestment of income. Ibbotson U.S. Long-Term Government Bond Index is measured using a one-bond portfolio with a maturity near 20 years. S&P 500 Index is an unmanaged index considered representative of the US stock market. S&P GSCI Index is an unmanaged world production-weighted index composed of the principal physical commodities that are the subject of active, liquid futures markets.

Correlation indicates the degree to which two investments have historically moved in the same direction and magnitude. A greater positive correlation (+1.00 maximum) means the two investments have behaved more similarly; a greater negative correlation (1.00 maximum) means the two have performed less similarly.

Diversification does not guarantee a profit or eliminate the risk of loss.

Standard Deviation measures a fund’s range of total returns and identifies the spread of a fund’s short-term fluctuations.

©2014 Morningstar, Inc. All rights reserved. The information contained herein is proprietary to Morningstar and/or its content providers. It may not be copied or distributed and is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.

Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.

In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.

Investing in infrastructure involves risk, including possible loss of principal. Portfolios concentrated in infrastructure securities and MLPs may experience price volatility and other risks associated with non-diversification. Investment in infrastructure-related companies may be subject to high interest costs in connection with capital construction programs, costs associated with environmental and other regulations, the effects of economic slowdown and surplus capacity, the effects of energy conservation policies, governmental regulation and other factors.

Alternative investment products, including hedge funds and private equity, involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. There is often no secondary market for an investor's interest in alternative investments, and none is expected to develop. There may be restrictions on transferring interests in any alternative investment.

Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.

Most senior loans are made to corporations with below investment-grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid.

Short sales may cause an investor to repurchase a security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, exposure to potential loss is unlimited.