Trading Places: Mapping the Impact of Alts in a Traditional Portfolio
As the recent era of easy money draws to a close and economies globally reel from the impact of inflation, slower growth, and geopolitical disruptions, a traditional 60% equity/40% bond allocation has come under stress. Year-to-date, a basic 60/40 allocation would have returned -18.8%, and there are signs that the recent historical paradigm of negative correlation between stocks and bonds may be reversing, as stocks (-21.1%) and bonds (-15.7%) have moved downward in lockstep this year. Furthermore, over the 12 months to October 31, 2022, the fixed income component of a 60/40 portfolio contributed 15% of portfolio volatility, versus just 4% since the beginning of 2000.
If equities and bonds no longer provide an appropriate hedge against each other, then the need to find alternatives that can becomes even more pressing. However, as our detailed analysis in this paper will demonstrate, even before this apparent shift in the stock-bond correlation, building alts exposure into portfolios was already valuable. According to historical data, a model 20% portfolio allocation to alts would have both improved overall returns and reduced drawdowns in times of market stress. Furthermore, a simulation of outcomes, based upon historical performance data, suggests that downside risk reduction and higher returns are persistent benefits of adding alts to a portfolio.
Reducing Portfolio Losses
Hindsight shows that a small allocation to a combination of alternative asset classes and strategies would have notably improved portfolio performance over the last 15 years – which is the full time period in which there is historical data covering all the asset classes in our model portfolio (See Exhibit 1). The model portfolio in our analysis assumes an allocation of 20% to alts by reallocating proportionately from equity and fixed income. The alts component is composed of 8% private equity, 8% private credit, 2% private real estate, and 2% hedge funds.
Just as importantly, the addition of alts simultaneously reduce volatility. While volatility and risk are not
necessarily the same thing – the former is simply a measure of the magnitude of movements in both directions over time – lower volatility often contributes to a reduction in measures of risk, such as drawdowns or maximum loss. Alts have several attributes that can allow them to reduce volatility.
Alts’ ability to provide downside protection is reflected in the fact that they have, on average, captured only 27% of declines of traditional stock and bond portfolios over the drawdown periods in Exhibit 2, excluding the one still currently unfolding. Those benefits are notable when integrating a 20% alts allocation into a traditional portfolio.
Incorporating alts would have reduced portfolio losses by approximately 20%, on average, during periods of public market decline – an almost one-for-one reduction for each percentage allocation to alts.
A Perennial Alternative to 60/40
We wanted to more firmly establish that alts are additive irrespective of the market environment or performance of the traditional portfolio.
To do so, we used a Monte Carlo simulation to examine the relative performance of our model portfolio (with 20% alts) across thousands of theoretical return paths.
This type of simulation allows us to analyze the impact of alts on a 60/40 portfolio in a wide range of market environments. The Monte Carlo simulation found that the model portfolio with a 20% allocation to alts outperformed a classic 60/40 portfolio in all but 128 out of 10,000 runs.
The Monte Carlo simulations show us that, whether a 60/40 portfolio performed strongly or poorly, an allocation to alts would have made that performance better.
Alternative, but No Longer Niche
While they may be called alternative, alts are no longer exclusive or niche: Private market assets are currently valued at $23 trillion. These investments will likely, and necessarily, become ubiquitous components of a well-balanced portfolio.
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