Portfolio Diversification & Alternative Investments

April 10, 2018

Debunking the most common myths behind alternative investments.

 

 

Introduction

It’s safe to say we’ve all heard the term “diversification” when it comes to investing, but is it really as simple as “don’t put all of your eggs in one basket”? In today’s world, there are many “baskets” out there, so how do we know which baskets to pick and how many eggs to put in each?

Whether the markets are currently trending up or down, it is important to understand the principles of portfolio diversification and how the concept can be used as a risk-management tool. Since portfolio construction should never be thought of as a “one-size-fits-all” solution, in this article, we will cover the basics of diversification and how alternative assets can assist in making it work to your advantage.

What is Diversification?

At its core, diversification is a strategy that can be used to manage risk by placing different eggs into different baskets. Eggs? Baskets? I know what you’re thinking, “I thought we were talking about investing here…” Think of eggs as any security or holding, ie. you own Apple stock, while the basket may be defined by its asset class (debt vs. equity), sector (technology), or market value (large-cap). There are some baskets that tend to move together up and down, some that move in the opposite direction, and others that simply do not have any connection to other baskets - otherwise known as intermarket relationships. The idea is to spread out the eggs among the various baskets in a way that limits potential egg losses if one or more baskets falls. Simple as that, right? Not quite! Each egg is unique, just like the basket in which they’re in, making the process much more complicated. However, for the purpose of this article you hopefully have a better understanding of the concept diversification. We can now move forward to discussing methods that can be implemented to obtain a diversified portfolio.

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Asset Allocation Strategy

The traditional method for obtaining a diversified portfolio is the strategy of asset allocation, in which we are defining as, “allocating percentages of a portfolio, derived from individual risk and financial objectives, to different groups of similar investments, or asset classes, with the goal of minimizing risk.”

For years, asset allocation was fairly simple and only involved three traditional asset classes, or baskets - equities (stock), debt (bonds), and cash. However, given overall industry advancements and changes, there’s some argument as to how many asset classes exist today.

From the 2016 chart shown below, Charles Schwab uses twelve asset classes that break up the traditional equity and debt baskets into four smaller baskets, and four more for the non-traditional category, including REITs, commodities, and cash/equivalents.

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Source: The Schwab Center for Financial Research

What is the reason for adding additional asset classes? According to the article, the traditional three baskets were expanded in response to markets becoming more and more collelated over the years. Simply put, three asset classes were no longer enough to be achieve optimal diversification. Since asset correlations, or intermarket relationships, is a major component in understanding how to build a diversified portfolio, we must embrace asset class evolution to incorporate trend changes over the years.

 

Modern Portfolio Theory

“Risk” and “reward” are often used simultaneously, but it is important to also be aware of the other side of the coin, loss, and how diversification is designed to minimize it. Based on asset allocation, Harry Markowitz was recognized in 1952 by the Journal of Finance for his paper “Portfolio Selection” and pioneering idea of Modern Portfolio Theory, in which he later received a Nobel Prize for (Forbes). The complicated mathematical function is a method for the risk-averse, or those reluctant to take risks, to build portfolios that maximize potential profits, given a stated level of market risk. The theory assumes humans are inherently risk-averse and will only take on additional risk if there is an increase in expected returns.

A product of MPT is the Efficient Frontier.

According to TD Ameritrade, “...a portfolio exhibits risk and return characteristics based on its composition and the way those components correlate with each other. For each level of risk, there is an ‘optimal’ asset allocation that is designed to produce the best balance of risk versus return. An optimal portfolio will provide neither the highest returns, nor the lowest risk of all possible portfolio combinations. It will attempt to balance the lowest risk for a given level of return and the greatest return for an acceptable level of risk. This meeting point of each level of risk and reward, where optimal portfolios reside, is called the ‘Efficient Frontier.’”

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One thing you’ll notice in the above graph from TD Ameritrade’s version of the Efficient Frontier is the top line, private equity, which is part of the alternative asset class and non-traditional basket. According to the MPT, by including alternative assets in a portfolio, there is an increase in expected return that is above all of the other asset classes, or baskets, for a given level of risk.

Alternative Assets & Diversification

Although alternative assets aren’t new to the industry, for years, myths have kept this basket from being utilized to its fullest potential for many investors despite the benefits they carry.

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Myth #1Alternative investments are only available to the ultra-wealthy individuals and institutions.

In the past, there was definitely truth to this statement. However, product and regulatory innovations over the years has opened access to almost every investor. Woohoo! Alternative eggs for (almost) everyone!

The “JOBs” Act, a legislative deregulation achievement passed in the Obama-era, was a major victory that has since removed many barriers of entry for non-accredited investors to enter a non-traditional asset class. As Forbes outlines, “Another provision of the JOBS is Regulation A+, often called the ‘mini-IPO’ provision. This allows companies to raise up to $50 million from ordinary investors without the full process of going public and being subject to Sarbanes-Oxley and Dodd-Frank.” (Forbes)

 

Myth #2Alternative assets are more volatile than stocks and bonds.

Blackrock, the world’s largest asset manager states, “While some alternative investments can experience higher levels of volatility than traditional stocks and bonds, as a group, they are no more volatile than any other investment. In fact, many alternatives experience far less volatility than the stock market. Additionally, because they can use a number of different strategies and asset classes, alternatives can produce returns that have low correlations (or go up and down at different times) with traditional stocks and bonds. Adding alternatives to a portfolio containing only traditional stocks and bonds has the potential to lower its volatility.” Blackrock’s point of view corroborates Markowitz’s theory that alternative investments can achieve higher risk-adjusted returns than a traditional equity and bond asset allocation method.

 

Myth #3Alternative investments prevent investors from accessing their money when they want or need to.

Although there are alternatives that contain “lock-up” periods in which the investor is prevented from selling their stake for a predetermined amount of time, many others exist that offer daily liquidity for their shareholders. As Blackrock says, “As with all aspects of investing, there is a tradeoff between risk and return, and liquidity is no different. When investing in less liquid options, investors expect to be compensated with improved returns. This is called an ‘illiquidity premium.’” (Blackrock)

Alternative assets carry many potential benefits for investors, including optimizing diversified portfolios. While understanding the evolution of asset allocation, we were able to recognize the integral role this basket has, so at CFX Markets, we built our platform to put the last myth to bed by allowing investors the option of liquidity when they need it. By offering an efficient and transparent process for shareholders of non-exchange traded alternative assets access to liquidity, we look forward to more investors incorporating this non-traditional asset class in their portfolios.

Conclusion

From the traditional strategy of asset allocation, to Modern Portfolio Theory and the Efficient Frontier, to the benefits of including alternative assets, there are many options investors have when designing a portfolio to manage risk.

Although there are fundamental differences in how investors approach each, one commonality that they share is the goal of diversification. It is not as simple as “don’t put all of your eggs in one basket”, but we now understand the basis for asset allocation and the evolution from three traditional baskets into something much bigger and complex. Luckily, with modern technology and access to financial professionals across the globe, it is easier than ever to navigate these sometimes complicated waters.

 

 

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Securities offered through Sageworks Capital, Inc., an affiliated registered broker-dealer and member FINRA/SIPC. All investment-related information presented is for informational purposes only and does not constitute a solicitation or offer to sell securities.



 

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