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!
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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
Agreed. Have you seen Chris Cole’s work on portfolio design? He is founder of Artemis Capital and writes a fair amount. A great piece he wrote is on what he calls the “Dragon Portfolio.” He is recommending a combination of stocks, bonds, long volatility strategies, commodity trend and precious metals - all about 20% a piece.
Peter: (1) The subject of the post is whether or not alternative investments provide reliable volatility dampening. Please see my reply to, Ingmar, above. (2) I honestly don’t see a connection between the technical issues you identify (other than return smoothing) and the results presented. Nothing esoteric in what I did. As for return smoothing, I did not adjust for that; had I done so, the case for alts would be worse. See also my reply to Clayton. (3) There is a link in my post to my blog. There you will see a regression of alphas on alts exposure percentages that shows negative alpha down to 10% of assets. With alts, the more you have, the worse you did.
Richard: On point (2), to clarify: If I have understood your methodology correctly, you measured the ex-post 10-year volatility (or beta) of portfolios containing an average of ~60% alts and then you solved for the weightings of a traditional stock/bond portfolio (72/28) that would have exhibited an equal ex-post 10-year volatility (or beta) over the same period.
If that is indeed what you did, then you would have implicitly assumed that the returns of alt-heavy portfolios are lognormally distributed (they are not for all the technical reasons listed in my previous post), which is the same logical error made by alternative investment promoters when they make low-vol claims.
If the alternative investments held in the alt-heavy portfolios you measured experienced a outlier return in your already very limited sample of historical returns, then the ex-post volatility / beta you measured would be overstated, and accordingly, so would the equity content (72%) of your benchmark stock/bond portfolio.
And since the decade in question was favourable for equities, that could mean the performance differential you observed (1.6%) is either overstated or non-existent.
Peter, Can you provide evidence of “volatility dampening” (apart from that associated with return-smoothing or reduced beta) brought about by the use of alternative investments for a large sample of institutional funds? That is the subject of my post, and I dare say one of greater interest to readers of this blog than a debate of the pros and cons of normal vs. lognormal distributions in the analysis of returns.
Hi Richard,
I’ve actually been constructing investment portfolios for over 19 years, and yes, I have plenty of real world evidence that alternative investments, when intelligently combined and held in reasonable proportion, do dampen portfolio volatility - and I don’t need to data mine or back test to prove it.
Unfortunately, I also have plenty of real world examples of alts failing to provide the promised downside protection, some very recent and very extreme: in March 2020, a leveraged credit fund that was boasting a 10-year Sharpe of 3.0 experienced a 23-sigma event; that’s my whole point, volatility is a flawed and unreliable measure of alternative investment risk, and so any analysis that is based on it is also flawed and unreliable.
I acknowledge that critiquing is easy and producing original work is hard. Nonetheless, it is in all of our best interests to provide honest and fair critique even when we agree with the conclusions of our colleagues; and to accept the fair and valid critique of others, even when they challenge our work.
That was the spirit in which I posted my first comment, and also the spirit in which I post my last.
Peter, very nicely put, thank you. Best to you. Richard
Hi Richard,
This is a very interesting article: simple and factual.
Have you make a distinction between downside and upside deviation?
I would also be interested to obtain the regression details.
Vincent
Please see my reply to Andri for regression stats.
Dear Richard,
I read your post with great pleasure and a smile on my face. It is so gratifying to see how meritless claims, so abundant in the social networking space today, are easily exposed with elementary analysis.
Looking forward to more of the same!
In addition to peter’s points above, you also use a US stock index, best performing region in the world the last decade. Use Acwi (or some other investable global index) like structure of most institutional portfolios and you won’t see same outperformance of simple stock bond portfolio with as much or more risk. Not defending alts per se but think this analysis doesn’t control for enough factors to condemn them either.