How Do Alternative Investments Fit Into a Diversified Portfolio?

These strategies vary, and so do their roles.

Karen Zaya 20 June, 2023 | 4:51AM
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Asset classes

In our recently published 2023 Diversification Landscape report, we took a deep dive into how different asset classes performed in the past couple of years, how correlations between them have changed, and what those changes mean for investors and financial advisors trying to build well-diversified portfolios.

Alternative strategies, as the name suggests, offer something fundamentally different from mainstream asset classes. Morningstar defines these strategies based on their ability to modify, diversify, or eliminate traditional market risks. There is considerable variation between strategies, though, and identifying appropriate benchmarks is tough. For that reason, we used the Morningstar Categories for funds as proxies for the most common strategies rather than market indexes. (Note: The categories referenced in this report reflect the classifications that Morningstar introduced in early 2021.)

Alternatives classified as diversifiers include the equity market-neutral, event-driven, options-trading, relative value arbitrage, and multistrategy categories. These incorporate various traditional market risk factors found in equities, alongside nontraditional or alternative risk factors or betas, to offer a more diversified source of long-term returns. Nontraditional betas include factors such as carry, momentum, and trend, but because these are combined with residual traditional risk factors, they are still exposed to losses during market crashes. The most common strategies in this group—equity market-neutral, event-driven, and relative value arbitrage—typically have little to no sensitivity to moves in equities markets. In all three cases, they tend to trade securities both long and short against each other rather than trading against the overall market.

Strategies defined as opportunistic (macro trading and systematic trading) generally focus on absolute returns, meaning they aim for positive returns in all markets and focus more on capital preservation. Managers of these strategies move in and out of long and short positions as opportunities arise. Opportunistic funds tend to lose less in drawdowns but also come with more complexity. Sometimes these managers bet the market will continue moving in the same direction, sometimes they wager it won’t, and they often switch or hedge their bets. Market expectations can often get caught out of step, so they use sophisticated risk-management systems to manage their myriad exposures.

Recent Performance Trends

As equity markets sank more than 19% in 2022, Morningstar’s alternative categories delivered returns ranging between positive 16.9% and negative 9.2%. Trailing three-year correlations with the Morningstar US Market Index varied between 0.98 and negative 0.11, with five categories above 0.77. Unsurprisingly, categories with the weakest links to stocks fared the best with respect to returns. The systematic trend (negatively correlated) and equity market-neutral (very weakly positively correlated) categories posted positive returns of 16.9% and 5.9%, respectively. What might evoke a little more surprise is that the macro-trading category nearly broke even in 2022 despite a 0.88 correlation with equities. This was due to its low equity and bond beta, which is an important consideration when assessing alternative categories’ performance.

A matrix containing three-year correlations of alternative categories and the Morningstar US Market Index.

Correlation figures tell us how directionally aligned these alternative categories’ returns are with the equity market’s returns but do not convey the magnitude of that alignment (or nonalignment). Thus, it’s also helpful to consider their respective betas (computed versus the Morningstar US Market Index), which provide insight into alternatives’ degree of sensitivity to equity movements. Alternatives exhibited three-year trailing equity betas between positive 0.47 and negative 0.04, with six of seven categories measuring below 0.26—meaning only 26% of their returns could be attributed to moves in the equity markets.

For example, the event-driven category lost only 1.75% in 2022, faring significantly better than a 60/40 portfolio. This was due to an equity beta of only 0.23. Based on correlations alone, investors might have expected the category to move in the same direction as equity markets but not to such a small degree. By factoring in the equity beta, one might estimate something around a 4% loss (computed by multiplying the category’s beta of 0.23 by the equity market’s 19% loss), which is close to the observed category performance. The remaining categories all posted negative returns. Options trading, a 50% hedged equity category, lost the most (9.2%), which is unsurprising given it had both the highest correlation (0.98) and equity beta (0.47).

Longer-Term Trends

Over longer periods, correlations have been relatively stable for most categories, but some differences have arisen. Near-term correlations for macro trading have increased over the past decade. On the other hand, correlations for equity market-neutral and systematic trend have decreased in recent years. Equity betas have shifted most noticeably for options trading and systematic trend, whose recent figures have increased and decreased, respectively.

A graph with the rolling three-year correlations of alternative categories versus the Morningstar US Market Index

Portfolio Implications

Investors seek out alternative strategies for reasons such as reducing drawdowns, seeking a wider range of risk factors or asset classes, or more portfolio stability. In other words, alternative strategies are not primarily viewed as return generators in bullish markets. Given the asset class’ primary purpose to complement and diversify an overall portfolio, it shouldn’t come as a surprise that in seven out of the past 10 calendar years, all seven alternative categories underperformed the Morningstar US Market Index, often by substantial margins. The benefit of alternatives becomes more evident when one considers intense market selloffs, such as the fourth quarter of 2018, the first quarter of 2020, and the first half of 2022′s market correction. The lower equity sensitivity translates into more modest losses during equity market drawdowns and in some cases even positive returns.

From a portfolio construction perspective, though, investors must remember that exceptionally low betas have a major impact on portfolio performance even when correlations seem high. Despite trailing U.S. equities by a wide margin over the past decade, a 20% allocation to most categories of alternatives would have improved risk-adjusted returns versus an all-equity portfolio or a balanced 60/40 portfolio. The strategies with the lowest equity betas—systematic trend, event-driven, relative value arbitrage, and equity market-neutral—all matched or increased the portfolio’s Sharpe ratio.

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About Author

Karen Zaya  is a manager research analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. She covers multi-asset and alternatives strategies.

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