By Roger Nusbaum, AdvisorShares ETF Strategist
Invesco ran a commercial on CNBC for liquid alternative funds with the tag line "goodbye 60/40, hello 50/30/20," the implication being 50% to equities, 30% to fixed income and 20% to alternative strategies.
Where alternatives used to be more about reducing volatility, the conversation is shifting to include bond market substitutes due to what seems like an increased likelihood of lower for longer for interest rates.
It is a positive that the conversation is expanding and presumably more market participants are taking the time to learn about alternatives. I am pretty skeptical that a 20% allocation is the answer. Back in the middle of the financial crisis a reader left a comment on the Seeking Alpha version of one of my posts that essentially advised putting it all into Hussman and not worrying about it. While it is debatable as to whether Hussman counts as alternative, his strategy is obviously not straight buy and hold of an equity portfolio. I was consistent to point out that the equity market was not permanently broken and I don't think the bond market is now permanently broken. Too much in alternatives and pretty soon it is the equity and bond exposure that is the alternative.
There are segments of the bond market with more than adequate yields but they are volatile, so in the context of 60/40 you probably don't want 40% in the parts of the bond market that are almost as volatile as the equity market. You probably want some in those segments and you probably want more than you would have considered 15 years ago, but not 40%.
I am of the opinion that some portion of a fixed income portfolio needs to be in the low-yielding stuff to help offset/manage the increased volatility from the higher-yielding stuff. Things like market neutral, absolute return, hedge fund replication and managed futures can play a role in between those two extremes in terms of offering the potential for bond like volatility (most of the time) with a total return that equates to an adequate yield.
There are other strategies in addition to the above four but using them requires really taking the time to understand the pros and cons, more so than I think most people do. For example, I am a believer in managed futures but it appears to struggle when equities are raging higher. I am not sure I would want an absolute return right now that just used fixed income products or derivatives. Where yields have been so low for so long, no one should be surprised by some sort of never happened before scenario that no one sees coming.
It is crucial to have the correct expectations about alternatives (for anyone using or planning to use them). Gold is the easiest example I can think of. I believe in gold as an alternative to equities. I have been saying the same thing about it since I started blogging, which is that it tends to not look like the domestic equity market and that if gold is the best performing asset you have, then things are probably not so hot everywhere else.
Nothing has changed in this dynamic. Equities struggled in the 2000s and gold did well. For most of this decade equities rocketed higher and gold did poorly. This year equities have traded sideways and gold has gone up. There are no absolutes, just the tendency, which is my expectation, and so generally this works. The next time equities have a sustained run higher I would expect gold to again perform poorly or otherwise struggle.
Alternatives will not give you an annualized 8% riskless return; that is the wrong expectation. But they can help smooth out the ride when used in moderation. This was my hope before the financial crisis and turned out to be my experience with them during the crisis. The right expectation combined with moderation can lead to successful implementation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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