How Alternative Investments May Help Improve Returns While Reducing Risk

by: Invesco US

By Walter Davis, Alternatives Investment Strategist on Jul 17, 2018, in Alternatives, Equities, Fixed Income

What to expect from the performance of alternatives

Given the market turbulence experienced so far in 2018, I am not surprised that interest in alternative investments (alts) has picked up. For anyone trying to figure out how to incorporate alternatives into a portfolio, it's critical to have proper expectations about their performance and how that might differ from traditional equities and fixed income.

Examining the past performance of alternatives

A picture is truly worth a thousand words. I have previously used the chart below to illustrate several key points about the performance of alternatives, and all bear repeating here. The chart compares the historical performance of alternatives to that of equities, fixed income and the traditional 60% stock/40% bond portfolio for a period of nearly 20 years.

Overall alternatives performance from August 1998 through May 20181

Overall alternatives performance from August 1998 through May 2018

Source: Invesco. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. Returns shown are annualized.

To some investors, this chart may be surprising. As you can see, the alternative portfolio generated a slightly higher long-term return than equities, fixed income or a traditional 60%/40% split of the two. At the same time, the alt portfolio was much less risky (as measured by standard deviation and maximum drawdown) than the equity or equity/fixed income portfolios.

Alternative performance in different market environments

The chart above clearly highlights the similarities and differences in long-term returns, risk as measured by standard deviation and maximum drawdown between alternatives and three different examples of traditional investment portfolios. However, in viewing these long-term results, it is not possible to discern how each performed during the various periods over the nearly 20-year cycle. Based on the chart, one might expect the similar average returns of equities and alternatives at the end of the period were similar throughout. That expectation would be false, as alternatives have historically performed differently than equities during different parts of the market cycle. For this reason, it is important to drill down further, as illustrated below.

Changes in performance during different market environments (August 1998 through May 20181)

Changes in performance during different market environments August 1998 through May 2018

Source: Invesco. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. Returns shown are annualized.

Returns are not consistent across different parts of the market cycle

When comparing the performance of alternatives to equities, fixed income or the 60%/40% blend of the two during different parts of the market cycle, some patterns emerge. During bull market periods (Tech bubble, Debt run-up, Post-crisis market), alternatives have historically generated positive returns but lag those of the other three portfolios. During the two bear market periods shown (Bursting of the tech bubble and the Financial crisis), alternatives outperformed equities and the 60%/40% blend, but trailed fixed income. In the first bear market period example, alternatives generated a positive return, while in the second (Financial crisis), the return was less negative than for equities.

Due to the reduced volatility illustrated in the first chart, the performance of alternatives over the period was a little less dramatic than for equities, with a slightly higher return but less volatile moves up or down. Over the same period, equities generated significant returns, but also experienced sharp periods of negative performance and trailed alternatives. The 60%/40% portfolio was the third highest over the period, with fixed income returns positive but significantly behind the other three.

Understanding alt returns

When considering alternatives, it is critical to understand the nature of returns during different parts of the market cycle. For nearly 20 years, the example alternative portfolio underperformed during periods of stock market strength but outperformed during periods of stock market weakness. Over the long term, this portfolio of alternatives outperformed equities, fixed income and a 60%/40% blend of the two. Of course, there is no guarantee this pattern will repeat itself, and history also suggests that long periods of market growth and low volatility will result in alternatives underperforming.

About this series

This summer, I am publishing a series of blogs covering the basics of alternative investments, with an emphasis on alternatives available via mutual funds. I have previously covered how alternatives can help portfolios in uncertain markets and why investors should consider diversifying into these assets. My next blog will focus on how to incorporate alternatives into a portfolio.

1 Source: Invesco, August 1998 - March 2018. Alternatives portfolio is represented by a portfolio consisting of: 20% Inflation-hedging assets; 20% Principal preservation strategies; 20% Portfolio diversification strategies; 20% Equity diversification strategies; 20% Fixed income diversification strategies. Traditional 60/40 portfolio is represented by 60% S&P 500 Index and 40% Bloomberg Barclays US Aggregate Bond Index. Equities are represented by the S&P 500. Fixed Income is represented by the Barclays U.S. Aggregate Bond Index.

20% Inflation-hedging assets are represented by 15% FTSE NAREIT US Real Estate Index Series, All Equity REITs and 5% Bloomberg Commodity Index. The 15%/5% split reflects Invesco's belief that investors tend to invest in strategies with which they are more familiar. 20% Principal preservation strategies are represented by the BarclayHedge Equity Market Neutral Index. 20% Portfolio diversification strategies are represented by 12% BarclayHedge Global Macro Index and 8% BarclayHedge Multi-Strategy Index. Multistrategy is underweighted in this example due to its potential overlap with global macro. 20% Equity diversification strategies are represented by the BarclayHedge Long/Short Index. 20% Fixed income diversification strategies are represented by the 20% BarclayHedge Fixed Income Arbitrage Index.

Important information

Blog header image: Zanna Lecko/Shutterstock.com

Standard deviation measures a portfolio's or index's range of total returns in comparison to the mean.

Maximum drawdown refers to the largest percentage drop in value during the measured period.

The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.

The Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.

The FTSE NAREIT All Equity REIT Index is an unmanaged index considered representative of US REITs.

The Bloomberg Commodity Index is a broadly diversified commodity price index.

The BarclayHedge Equity Market Neutral Index includes funds that attempt to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country.

The BarclayHedge Global Macro Index includes funds that carry long and short positions in any of the world's major capital or derivative markets.

The BarclayHedge Multi-Strategy Index includes funds that are characterized by their ability to dynamically allocate capital among strategies falling within several traditional hedge fund disciplines.

The BarclayHedge Long/Short Index includes funds that employ a directional strategy involving equity-oriented investing on both the long and short sides of the market.

The BarclayHedge Fixed Income Arbitrage Index includes funds that aim to profit from price anomalies between related interest rate securities.

Past performance is not a guarantee of future results.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.

Alternative investments can be less liquid and more volatile than traditional investments such as stocks and bonds, and often lack longer-term track records.

Alternative products typically hold more nontraditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.

Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.

Investments in real estate-related instruments may be affected by economic, legal or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small- and mid-cap companies, and their shares may be more volatile and less liquid.

Diversification does not guarantee a profit or eliminate the risk of loss.

This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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All data provided by Invesco unless otherwise noted.

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How alternative investments may help improve returns while reducing risk by Invesco US