Alternative Strategies Allocation

by: Alex Gurvich

Recently my partner and I participated in the webinar about Alternative Investment strategies and how to position them in your portfolio. We also discussed the types of alternative strategies that are out there.

We also talked about what is commonly called the Endowment Model and below is the performance of the Harvard Management Company, which manages the endowment of Harvard University.

Historical Investment Return

Harvard Management Company

Policy Portfolio Benchmark

60/40 Stock/Bond Portfolio

1 year

21.4%

20.2%

19.5%

5 years

5.5%

4.3%

4.9%

10 years

9.4%

6.7%

4.3%

20 years

12.9%

9.8%

8.3%

Source: Harvard Management Company Endowment Report September 2011

So how and why do we need Alternative Investment strategies? Just because Harvard is using these strategies might not be good enough for us, so let’s explore further. The basic reason for using these strategies is to improve the risk/reward profile of your portfolio, in a common language what it means is that you reduce your portfolio risk a lot, while you reduce your portfolio return a little.

The reason is good, and the motivation is pretty clear. The investment environment is not great -- slow recovery, uncertain political direction in Washington, European euro crisis, Middle East turmoil, all contribute to our anxieties and fears. The markets are quite unpredictable, with high correlation between assets and geographies and high volatility. What we want and need is some safety, as we certainly don’t want the repeat of 2008, our primary objective is not to lose our principle investment amount. As Mark Twain famously said that he is interested in the “return OF his money, rather than return ON his money”.

So how do we achieve this. In order to answer this question, let’s look at where returns come from. In general it is well known that investment decisions by managers in the terms of selection of stocks and timing does little to improve performance and actually hurts performance over a long time. According to an influential study by Brinson, Hood and Beebower, stock selection and market timing do not matter nearly as much as how you mix the building blocks of your investment portfolio. They concluded that asset allocation and not stock selection, explained over 90% of investment return. Although the study has been controversial, the authors are clear that “individual asset class policies, with given weights and broad market representation for returns, appear to dominate portfolio return variations and, by extension, the returns themselves.”

What it means is that market timing and stock picking actually decreased portfolio return. In other words, the key to a winning investment strategy is not so much to choose the right investment or to decide on the best time to buy or sell but to choose the right asset mix and then to stick to it.

The classic portfolio allocation, which is 60/40 to stocks and bonds needs to be improved upon. A typical improved asset allocation is to include international stocks and bonds and emerging markets stocks and bonds. This does bring out better diversification and it does get us closer to better risk/reward profile of our portfolio, but it is not enough. The new asset allocation is to divide portfolio into what I call Asset Categories – financial, physical, hard, other equity and alternative assets.

Stocks and bonds are the financial assets. Physical Assets are commodities and things that we consume, Hard Assets are real estate, art and things that last a long time, other equity are private equity and venture capital funds, and Alternative Assets are Absolute Return, Hedged and Long/Short strategies.

The reason the alternative assets help us achieve a better risk/reward profile is because Alternative Asset strategies provide uncorrelated to major indices returns, while lowering volatility. The investment objective of these funds are to earn cash like returns, with several hundred basis points.

Instead of the old 60/40 split I would recommend allocating 50% to financial assets (including domestic, international and emerging markets stocks and bonds), 10% to physical assets, 10% to hard assets, 10% other equity and 20% could be allocated to hedged strategies

If you look further at allocations that Harvard has in the portfolio you will notice the faster growing asset category is Absolute Return, while most of the asset categories decreased, the absolute return allocation increased by 30%, from 12% to 16%.

The evolution of the Policy Portfolio

1995

2005

2012

Domestic Equities

38%

15%

12%

Foreign Equities

15%

10%

12%

Emerging Markets

5%

5%

12%

Private Equities

12%

13%

12%

Total Equity

70%

43%

48%

Absolute Return

0%

12%

16%

Commodities

6%

13%

14%

Real Estate

7%

10%

9%

Total Real Assets

13%

23%

23%

Domestic Bonds

15%

11%

4%

Foreign Bonds

5%

5%

3%

High Yield

2%

5%

2%

Inflation-Indexed Bonds

0%

6%

4%

Total Fixed Income

22%

27%

13%

Cash

-5%

-5%

0%

TOTAL

100%

100%

100%

Source: Harvard Management Company Endowment Report September 2011

If you follow this type of portfolio allocation scenario, you will diversify your portfolio, reduce risk and in these uncertain times you will sleep better at night.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.