Benjamin Graham, the grandfather of modern investment theory, talked of two asset classes forming the basis of an investment portfolio: equities and bonds. In recent times, however, this has expanded to include several more, one of which is ‘alternatives’.
What are alternatives? Quite simply, they are investments that employ an alternative strategy to the rest of the portfolio. If that strategy is negatively correlated (moves in the opposite direction) to other assets held in the portfolio, it can add value by providing greater diversification and reducing portfolio volatility in times of uncertainty for other asset classes.
In order to achieve the above, picking the right alternatives within a portfolio is key. Some alternative strategies aim to provide a high level of income which can be valuable in the current landscape of dividend cuts and ultra-low, or even negative, bond yields. Other alternatives focus on trend following, infrastructure, commodities, or hedge fund strategies.
One of the most popular alternative investments to hold in a portfolio is the commodity asset, gold. Historically, gold has acted as a hedge in times of severe volatility in equity and credit markets. This was particularly true earlier this year when equity markets were at their most volatile for over a decade.
This is illustrated in the chart below which tracks the performance of gold alongside the global stock market from January through to the end of June last year.
As you can see, from mid-February through to April, gold acted as a valuable hedge by delivering positive returns whilst equity markets suffered a severe downturn. By allocating a small portion of your portfolio to this alternative asset, it would have lowered the overall volatility of the portfolio whilst at the same time limiting the downside during the market crash.
Why is this important? At the most volatile point in markets, investors are most susceptible to making bad investment decisions. By ensuring there are assets in their portfolio that smooth the investment journey at times like this, it can help them weather the storm and stay invested in line with their long-term objectives rather than make mistakes in line with their short-term fears.
It is important to remember that no one can accurately predict the future performance of each asset class they hold in their portfolio. The strength of and type of correlations between different asset classes can vary over time. There will be periods when everything moves in the same direction, as happened during April through June in the chart above. That said, we can make sensible asset allocation decisions based on historic performance to ensure that investors have a suitably diversified portfolio which is set up to match their attitude to risk and long-term objectives.
In conclusion, alternatives as an asset class can undoubtedly play a valuable role as part of a modern investment portfolio. If well managed, they act as a diversifier and their value often comes to the fore during times of extreme market behaviour. We think of it like your portfolio’s seatbelt; you often do not fully realise the benefits of wearing one until you experience a crash.
Written by Philip Feast and Sam Chedzoy.
General Disclosures: This article is based on current public information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The information, opinions, estimates and forecasts contained herein are as of the date hereof and are subject to change without prior notification. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. The price and value of investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.