Don't Get Carried Away With Alts

Charlie Bilello Tweeted out a table showing that the standard 60/40 equity/fixed income portfolio is currently on pace for its worst year since 1937. The whole world has been talking about the struggles 60/40 has been going through this year and many are exploring alternative strategies to try to mitigate the poor performance. 

This has been on my radar for years of course going back to before the financial crisis as interest rates went to lows even back then. Alts, or as I called them back then, diversifiers are something we've been exploring here for a long time and while I believe I was early to learn about and implement alts, the need to keep learning exists which leads me to a presentation I sat through this morning hosted by Franklin Templeton. I mostly just sat in on the first session called Beyond 60/40 which was queued up as a preamble to what I think might have been a bunch of sales presentations.

During the "bull run" 60/40 returned 9.9% annualized (per the presentation) but now expectations are for just 4.4% annualized which is why advisors need to think about using alts. The presenter cited David Swensen who very successfully managed the Yale Endowment using 70-80% in alts, most of which were illiquid alts. 

The needs for alts cited included needing to find returns that would exceed that 4.4% expectation, the need to buffer volatility and the need to protect against inflation. Different alts would do different things, they did not imply that one alt could do all three. That makes a good point about understanding and expectations of various alts. Inverse funds should go up when stocks drop for example while convertible arbitrage should be mostly a horizontal line with an upward tilt.

The alternative strategies that were most discussed were global macro, multi strategy, equity hedge, REITs, infrastructure, natural resources and even timber was mentioned. Learning about the benefits of timber reading about Jack Meyer from Harvard back in the 90's was my first introduction to the concept of alts. Private equity was a big one too, the presenter said "we all love private equity" which seemed odd to me.

This graphic does a good job of defining the landscape. Things like managed futures which we've spent time looking at this summer would likely be included in macro or multi-strategy. Volatility would likely also fit in there too. If you want to go through this exercise, their labels matter less than how you might want to label various alternative strategies you're partial to and would considering allocating to. A quick point is that IMO, you don't need anywhere near these many alternative strategies but sorting through more than you need to find what you think would be optimal is useful.

They really hit on using illiquid products which I am not a fan of. They might have better performance but they might not. They tend to be more expensive and if they're illiquid then they are not liquid (being a little jokey with that one). 

I listened to the first few minutes of the second presentation of the day and that presenter talked about a stable of 70 managers they use. That's obviously some sort of institutional shop and I am sure they are good at what they do but 70 is a whole lot of complexity. Keeping track of 20 would be very complex. I dipped out of this one as soon as he said "70."

Like with anything related to investing, we can make things as complicated or as simple as we want. I prefer making things as simple as possible. There's a balancing act here because although the virtual conference is obviously about selling product, it is also true that 60/40 has not worked this year and may not work for a while. A few posts ago, I argued that 60/40 actually stopped working years ago when the risk of owning low yielding, longer dated bonds first started all those years ago. People have been taking way more risk than they realized, only now are the consequences mattering. 

The presenter made several references to "what the client is trying to solve for" which is a good way to think of it. My approach is to replace some portion of the fixed income target. So is the fixed income target 40%, 30%, 50%? Whatever that number, how much of it do you need or want to substitute for? There's no wrong answer, how much? How much are you comfortable keeping in traditional income sectors? There are income sectors that minimize or avoid interest rate risk. You may not want any alts. You might think now is even the time to try to bottom fish income sectors that do take interest rate risk. 

I might be comfortable putting an enormous percentage into short term T-bills but it would not be my preference. A T-bill, an actual bill not a fund, will be a horizontal line. I want part of this 40 or 30 or 50% that I am trying to replace in the type of alts that should go up when the stock market falls. And I want more than one because you never know when something won't "work." Managed futures is working great during this event but what if it doesn't the next time? 

Would you put 5% of your portfolio into a single holding? What about 10%? How much is too much or too little? There's no wrong answer but if the fixed income target 40% then putting 10% into T-bills and 5% into several other things seems close to right, maybe even 10% into TIPS (I would go with short dated TIPS) then you have fewer exposures than the graphic up higher and it becomes far less daunting. Maybe we're talking about 3 or 4 alts for anyone who actually want to use them, I realize plenty of investors do not. 

Just because traditional 60/40 might be sub-optimal for a while doesn't mean it won't work. It can work, especially for participants still putting in money every paycheck. So in trying to manage against a sub-optimal but still effective approach, how much work and complexity do you want to add? No wrong answer but a matrix of a dozen different alts like the above is wrong for me.

Watching the presentation left me believing that I am not behind the curve on this. I do not want to go down the road of using alts that are not either exchange traded or traditional mutual funds. We've talked many times about simple complexity like a single strategy alt, complex complexity like a multi strategy fund with 9 different moving parts. Well non-traded alts are expensive complexity that may not have a lot of transparency. Like with just about any aspect of life, we all need to find our own groove for what works for us.