Have Alternatives Added Value?

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Includes: DFGEX
by: Eric @ SERVO

Summary

AQR founder Cliff Asness wasn't exactly impressed with my recent article on alternatives.

This time around, instead of just looking at behavior, I consider the merits of adding alternative assets to a traditional portfolio on a gross and net return basis.

In general, I find that a simpler approach to reducing portfolio volatilty works just as well, and a more conventional alternative asset class produces better returns over this period.

I wrote an article a few weeks ago, "Don't Get Sabotaged By Sophisticated Investing." The crux of it was that investors (and their advisors) seemed to be having a hard timing sticking with various alternative asset strategies in comparison to traditional stock portfolios.

To my surprise, my article found a second life from none other than AQR founder Cliff Asness. If you haven't read his response, be sure to check it out. He didn't necessarily have a dog in this fight, except that I used his funds as my proxy for alternative strategies. I pointed out in the article that these findings weren't a reflection on AQR, but instead the investors (and advisors) using their funds. But I was certainly happy for the response.

Where We (Sorta) Agreed

For some of my article, Cliff and I were in agreement. Based on the relatively short three-year period of time I looked at (due to the limited live history of some of the AQR funds), the Morningstar data reports very different behavior gaps between straightforward stock funds and more complex alternative strategies, with the former achieving much better "behavior-adjusted" results. Morningstar makes their investment/investor returns publicly available here.

Cliff also made casual reference, which I agree with, to the issues regarding behavior gap calculations on relatively new funds and funds in general. He didn't get into the details and I won't elaborate, but suffice it to say that "investor returns" are an imperfect proxy for real-world investor behavior (in much the same way that quoting DJIA or S&P 500 returns is never a perfect replication of your personal stock portfolio).

For this reason, I was careful to report the results across a wide cross section of funds in the stock/alternative categories, and not just one or two distinct strategies. For example, I reported the investment/investor results on every standard DFA Core Equity fund and every AQR fund listed in the "Alternative" category on their website.

Cliff's Beef

Cliff came away unsatisfied with my article and its conclusion. His main beef was that I didn't include a gross return comparison between a traditional portfolio and one that included alternatives. Behavior mattered, he conceded, but what if investors were able to stay the course with alternatives; did they then add value to a standard portfolio?

It's true that instead of tackling returns and behavioral outcomes, I opted only to focus on the latter point for the sake of brevity, because I had rarely seen it discussed previously, and also I didn't think readers would find a three-year return comparison very meaningful. But having already covered the behavioral topic, and because (at least) Cliff was interested, there's no reason we can't explore them together. This time around, I'll leave no stone unturned - returns, behavior, taxes, volatility, and drawdowns.

You Asked For It: Stocks vs. Stocks & Alts

We'll start with a diversified stock portfolio. In my first article, I reported the results on the DFA US Core 1, US Core 2, International Core, and Emerging Markets Core Funds. Sticking with these strategies, and using the approximate weights we find in the DFA Global Equity Fund (20/50/20/10), the table below reports the three-year returns and volatility for the 100% Stock Portfolio from 2014 to 2016. Next, I reduce the weights to stocks proportionally by 10%, 20%, and 30%, and include an equal-weighted allocation to each AQR alternative fund. See each link for greater details. I've summarized the results below.

Portfolio Mix

Annualized Return

Volatility

Max. Drawdown

100% Stock Portfolio

+5.0%

11.3

-13.4%

Stock Portfolio w/10% Alts

+4.9%

10.3

-12.0%

Stock Portfolio w/20% Alts

+4.7%

9.2

-10.5%

Stock Portfolio w/30% Alts

+4.6%

8.2

-9.1%

100% Alt Portfolio

+3.4%

3.7

-1.9%

Over this three-year period, we find that a globally diversified stock portfolio had returns of +5.0% per year. The equally weighted, 100% alternative portfolio returned +3.4% over this same period, but with about 67% less volatility than stocks. Adding alternatives to the stock portfolio produced predictable results: lower returns and lower volatility. Returns dropped from 0.1% to 0.4% per year, while volatility and maximum drawdowns fell by as much as 3.1% and 4.3%, respectively. So, looking at this three-year period, it appears as though adding alternatives to a stock portfolio had very little meaningful impact.

Now Can We Look At Behavior… And Taxes?

What happens, though, if we add back in behavioral costs and taxes? We covered behavior in the last article, so I'll just apply the data from that piece. And, on taxes, ideally, you'd want to hold these alternative funds in tax-sheltered accounts to avoid the higher relative tax drag, but if you're a high-net-worth investor with precious little deferred space (i.e., the typical SERVO client), you might be wondering how the numbers change once we factor in Uncle Sam's cut?

Portfolio Mix

Annualized Return

After-Tax Return

After-Tax Return NET of Behavior Gap

100% Stock Portfolio

+5.0%

+4.3%

+4.3%

Stock Portfolio w/10% Alts

+4.9%

+4.1%

+3.9%

Stock Portfolio w/20% Alts

+4.7%

+3.7%

+3.3%

Stock Portfolio w/30% Alts

+4.6%

+3.5%

+2.9%

100% Alt Portfolio

+3.4%

+1.3%

-0.5%

The stock portfolio lost 0.7% per year to taxes (0.5% if we substituted "Tax-Aware" versions of the Core funds, but we're trying to keep things consistent with the first article, so I didn't include them), and the returns after controlling for investor behavior were unchanged (data on DFA fund after-tax returns comes from DFA). The alternative funds, on the other hand, were far less tax efficient.

An equal-weighted portfolio of the alternatives lost -2.1% per year to taxes (source: Morningstar), almost 67% of the pre-tax return during this period. Net of taxes, the 100% alternative allocation's return fell to only +1.3% per year. Once we factor in the Morningstar-calculated behavior gap, we find the performance on the alternative portfolio went negative, to -0.5% per year.

Of course, adding any asset to a portfolio with a negative return net of taxes and behavioral costs will impair overall returns. Compared to the all-stock mix, the allocation with 10% in alternatives returned -0.4% per year less, the stock mix with 20% in alternatives returned -1.0% per year less, and the stock mix with 30% in alternatives returned -1.4% per year less. For small reductions in portfolio volatility and maximum drawdown, the opportunity cost of adding alternatives for real-world investors who pay taxes was fairly high over this period.

An Alternative To Alternatives?

Here I have to admit, I don't obsess over small differences in portfolio volatility. The clients I work with can't spend better Sharpe Ratios, so small differences in portfolio efficiency don't excite me (or them). But what if you're really concerned with portfolio statistical outputs, or what if you are simply a much more volatility-sensitive investor? Might I propose you have another option to consider? One that doesn't come with the same level of complexity as alternatives, but over this period, has accomplished approximately the same result? Yes, I'm talking about basic investment-grade bonds.

The table below reproduces the three alternative portfolios and compares them to allocations that use the DFA Investment Grade Bond Fund (another plain/vanilla strategy that buys short and intermediate government and corporate bonds) instead.

Portfolio Mix

Annualized Return

Volatility

Max. Drawdown

Stock Portfolio w/10% Alts

+4.9%

10.3

-12.0%

90% Stock/10% Bond

+4.9%

10.1

-12.0%

Stock Portfolio w/20% Alts

+4.7%

9.2

-10.5%

80% Stock/20% Bond

+4.7%

8.9

-10.6%

Stock Portfolio w/30% Alts

+4.6%

8.2

-9.1%

70% Stock/30% Bond

+4.6%

7.8

-9.2%

100% Alt Portfolio

+3.4%

3.7

-1.9%

100% Bond Portfolio

+3.5%

3.7

-3.6%

If you glance quickly at the table, you'll think that I've just reported the same data twice. The results on the stock/alternative portfolios and stock/bond portfolios are virtually identical in return, volatility, and maximum drawdown. The bond portfolio, however, only lost about -1.0% per year to taxes (50% less than the alternative portfolio) and most investors have an easier time sticking with boring fixed income. So when we look at adding alternatives to a portfolio compared to simply using investment grade bonds, we don't see a significant difference over this period. They look like a decent alternative to alternatives.

Or Maybe Just a Simpler Alternative?

Finally, let's look at a common approach I see with alternatives where a reasonable 10% allocation is added to a balanced portfolio, funded from a combination of stocks and bonds. So, instead of a traditional 60/40 stock and bond mix, I'll model a 55% stock, 35% bond and 10% alternative allocation.

Portfolio Mix

Annualized Return

Volatility

Max Drawdown

60% Stock/40% Bond

+4.4%

6.7

-7.8%

55% Stock/35% Bond/10% Alts

+4.4%

6.2

-7.0%

50% Stock/40% Bond/10% Global Real Estate

+4.9%

6.5

-6.6%

55% Stock/35% Bond/10% Global Real Estate

+5.0%

7.0

-7.3%

Again, I don't see a lot of difference. The returns are the same, volatility is reduced by 0.5 and the maximum drawdown shrinks by 0.8% with the portfolio that includes alternatives.

But maybe you look at this data and think, where's the harm in a small 10% allocation to alternatives? OK, how about REITs? Over this period, whether the allocation to the DFA Global Real Estate Fund (MUTF:DFGEX) came from stocks or a combination of stocks and bonds, there was a small improvement in returns without a dramatic increase in volatility or drawdowns. Again, we cannot say anything conclusive about three-year performance, but even here, the simpler approach to alternative investing worked better.

In Closing…

We've covered a lot of ground for a SERVO article, so let me summarize:

  • I've shown, over the last three years, that adding an allocation of the best alternative strategies (those managed by AQR) had a negligible impact on a stock portfolio - risk dropped some, as did returns.
  • When I factor in behavior and taxes, I find that adding alternatives to a stock portfolio becomes far more costly.
  • And, for those who prize the small reduction in volatility achieved by the alternative allocations over the last three years, I show that a straightforward allocation to investment grade bonds has produced about the same result, likely with less real-world frictions.
  • Finally, for those investors and advisors who just have to "upgrade" their stock and bond allocations with something alternative, I suggest looking at a basic Global Real Estate strategy.

Finally, to answer Cliff's question in his article ("how much you in for?"), I won't be adding any money to alternatives anytime soon, either for my clients or my personal portfolio. Those are just my views, and they wouldn't be any different had the last three years turned out much differently. My investment process just happens to be a simpler one - I decide on an appropriate stock/bond split, diversify across small/value stocks globally, and fight like hell to stay the course.

This, in my experience, is already asking a lot of the average investor - to avoid bailing out during the next bear market with a stock-heavy portfolio, and avoid giving up on foreign diversification or a small/value tilt during the next great run from the S&P 500. There's a limit to how much I can ask from my clients, and I already think I've pushed them far enough.

But for other investors (or advisors) who want to go the alternative route with some of their (or their clients') wealth, I'd suggest you first consider adding a Global REIT fund to your stock and bond mix. If REITs aren't enough, then I'd look at AQR exclusively. I wouldn't trust another manager in this space with my lunch money, let alone my retirement savings.

My advice: Make sure your clients have enough tax-deferred space to fit these in, and are willing to put up with unconventional return patterns and a strong commitment to buy out-of-favor strategies. Without the discipline to stay the course, the question of whether alternative assets add value is irrelevant.

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Past performance is not a guarantee of future results. Index and mutual fund performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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