Are Alternatives Substitute For Equities?
By Roger Nusbaum, AdvisorShares ETF Strategist
The Washington Post had an article about compounding stressors from everyday routine leading to serious health problem. By everyday routine they were talking about things like commuter traffic or just generally running late. The article implied that only big, life-event stressors like spouse dying could be harmful so if routine stressors are new for being harmful then I am not surprised.
The idea of reducing stress by placing yourself in fewer stress-inducing situations resonates with me personally and professionally. Personally, in that I have been working from home since my mid-thirties so no traffic and far fewer frustrating encounters with people at the office and professionally in that I have long advocated using diversifiers (now called alternatives) to manage portfolio volatility. We know that volatility causes people to reach a breaking point where they do self-destructive things, portfolio-wise. Managing volatility provides the opportunity to put clients in fewer situations where they might reach their breaking point.
Related to the above about portfolio strategy, Larry Swedroe’s latest at ETF.com is titled Active Alts Don’t Outperform. Larry has plenty of numbers to make his case that they don’t outperform in nominal terms, but they do have lower standard deviations than equity funds. He seems to also be saying they don’t outperform on a risk adjusted basis. The article focused on long short equity and market neutral.
If I am reading him correctly, I think he is framing the function of alternatives incorrectly on a couple of different levels.
We’ve said here countless times that equities are the asset class that goes up the most, most of the time. Any other asset class exposure is likely to underperform equities most of the time. This includes bonds, commodities and various alternative strategies. These other asset classes by virtue or their standard deviations, correlations to equities or both can help offset some portion of the volatility that goes with whatever portion is invested in equities.
One truism about diversification is that if everything you own goes up with the market then it will all go down with the market which doesn’t make for effective diversification. The only thing you’d be diversifying might be single issuer risk. Diversification means owning things that don’t behave like the stock market. Where Swedroe talked about long/short, I tend to think of that as usually being an alpha seeking, bull market strategy like 130/30 as an example. In that context it kind of doesn’t even fit in the topic he’s discussing. If a manager is using long short to seek a market neutral or absolute return type of result, I would put merger arbitrage in this category, that would be a different story.
Diversifiers (alternatives) can help with managing the volatility of the value of the overall portfolio. Contrary to what Swedroe appears to be saying, market neutral, as one example, is never going to outperform positive stock market gains. If it does, it’s not market neutral.
I write all the time about having the correct expectations for alternatives but of course you need the correct expectations about anything. I’ve said dozens of times, I never expect gold, an alternative, to be the best performing thing I own. If it is then chance are things in the rest of the world aren’t going so well. A couple of times, gold has been the better performer versus equities and sure enough equities struggled when that happened.
Nothing about alternatives may appeal to you but the value they might be able to add, repeated for emphasis, is not outperforming equities for more than any short period of time, they might be able to help over a short period when equities are going down a lot. With that as the proper expectation, then decide whether or not they make any sense for you.
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