Devotees of alternative investments have for many years claimed that alt-heavy investors perform better than stock-and-bond investors and enjoy “volatility-dampening,” to boot.
In a recent LinkedIn post, a senior CAIA Association executive reiterated this claim, saying:
“The endowments that have allocated larger chunks to Alts materially outperform a 60/40 in the LT. More importantly, they see significantly less volatility and draw down risk.”
No hedging there on the merits of alts — more return, less risk.
It so happens that I recently examined the performance of a group of large educational endowment funds during the 10 years ended 30 June 2018. I focused on endowments with assets in excess of $1 billion that had an average allocation to alternative investments of nearly 60% over the study period. I created a composite of returns for these investors using National Association of College and University Business Officers (NACUBO) data. Then I created an equivalent-risk benchmark for the composite using returns-based analysis. (The equivalent-risk passive benchmark actually turned out to be 72% stocks and 28% bonds.)
I found that the endowment composite underperformed the equivalent-risk passive portfolio by 1.6% per year. Underperformance of 1.6% a year over a decade ain't hay.
In the course of that work, I also examined the proposition that alts dampen portfolio volatility relative to a 60/40 portfolio. In simplest terms, I found that the annualized standard deviation of the endowment composite returns was 11.7% compared with 9.4% for the 60/40 portfolio comprising the Russell 3000 and the Bloomberg Barclays Aggregate Bond Index. In other words, the alt-heavy portfolios were 24% more volatile than “60-40.”
So much for a central element of the raison d'etre for institutional investment in alts. Over a decade, the alts-heavy endowments were more, rather than less, volatile than “60-40.”
What about performance? The diagram below is a regression of the endowment composite against the 60/40 portfolio. The slope (beta) is 1.22. The intercept of the regression (alpha) is -3.7% per year (t-statistic of -4.0).
So much for the claim that alts-heavy endowments outperform “60/40.” The endowments underperformed by a wide margin on a risk-adjusted basis, with 22% greater market-related risk.
Bottom Line
My research reveals the much greater extent to which public market pricing is reflected in the returns of private market real estate, private equity, and hedge funds since the global financial crisis (GFC). Nowadays, alt returns are animated by returns observed in stock and bond markets.
Consequently, there is neither reason (logic) to expect alts to be “risk dampeners” nor evidence that they have been such since the GFC.
Caveat emptor!
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Baac3nes
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images / Ascent / PKS Media Inc.
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.
26 Comments
This is a great read. Are you able to share your regression calculations for applied learning purposes?
Sure. Can you provide me an email address so that I might do so?
The regression stats are: beta = 1.22; R2 = .971; intercept = -3.69% (t of -4.0); and std error of regression of 2.11%.
My two favorite rules of investing apply.
1) Don’t try to time the market.
2)Timing is everything.
How many “average investors” are allowed to enter “alternative investments” at the bottom?
Not really surprising in a 10-year bull market where both stocks and bonds performed well. How about longer timeperiods in which (at least one) a full economic cycle is included?
“Volatility dampening” is a form of risk mitigation, no? Another form is insurance against loss from fire damage. Would you purchase a policy that contained the following language? “The insurer reserves the right to NOT honor claims for up to a decade at a time without notice.” In fy 2009, the alt-heavy endowment composite lost ~21% of its value, compared with ~14% for 60/40. For sure somebody’s house burned down in that year.
When do you need volatility dampening the most? In economic downturn. Ten years, of which most represented a bull market, don’t really provide evidence of whether any portfolio is a good volatility dampener. A longer historical period is needed to be more conclusive. Also it would be interesting to know which alts are included and in which percentages in the alt heavy 60% portfolio. Not sure if private equity for example has to be seen as vol dampener or more as return enhancer?
10 years isn’t a very long performance or risk measurement period though. What if this same exercise was done for the 1970s decade or others (if possible)?
The subject of the post is whether or not alternative investments provide reliable volatility dampening. Please see my reply to, Ingmar, above.
I agree with your overall conclusion that the benefits of alts are often overstated, particularly in marketing materials and occasionally by financial professionals that specialize in the field.
That said, I think your analysis invites some fair questions and comments:
1. Your analysis covers a single decade, which is too short a period to be considered conclusive. Have you considered extending it?
2. If you constructed an equivalent-risk traditional benchmark using returns-based analysis, then are you making the same error as promoters of alternative investments when they make dubious low-vol claims? That is, failing to properly account for skewness, higher tail-risk, financial leverage, use of derivatives, low-frequency pricing, appraisal smoothing, etc...
3. The question of greatest interest is whether reasonable allocations to alternative investments can improve a traditional, balanced and diversified portfolio’s risk-adjusted returns. I suspect the answer to this question is potentially yes, but I also believe that the optimal allocation to alternative investments is in the 0 - 40% range, i.e. much lower than the 60% average allocation that you mention above. It would interesting to see, at these lower allocation levels and with 10% position limits per strategy, whether or not alternative investments make good portfolio diversifiers.