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Adding alternative investments to a portfolio may offer investors an opportunity to achieve increased diversification, lower correlation to traditional asset classes and lower portfolio volatility.
Increased diversification. Most investors understand the basic argument for diversification, or "not putting all your eggs in one basket." While diversification does not assure a profit or protect against loss in a declining market, a diversified portfolio typically exhibits less risk than the weighted average of individual risk in the underlying positions. Investors seeking diversification in a portfolio may combine stocks with bonds and cash (traditional investments). As trade-offs exist between bonds and cash, however, a portfolio that includes both traditional and non-traditional (alternative) investment strategies, versus one that uses fixed income as the diversifier, may offer increased diversification and the opportunity for better returns.
Lower correlation. Alternative investment strategies, for the most part, are not highly correlated to one another or to traditional asset classes and therefore, behave differently in varying market conditions. The low correlation moderates the effect on the portfolio from shocks that may hit certain markets, asset classes or investments. If an investor's goal is to secure higher returns at a lower level of risk, then adding alternative investments to the traditional portfolio may be an attractive option.
Lower portfolio volatility. Beyond the ability to reduce risk as portfolio diversifiers, the low correlation also lowers portfolio volatility, resulting in more stable returns over time. Moreover, many alternative strategies also exhibit very low volatility, versus equities, when considered in isolation.
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| Efficient Frontier - Including Allocation to Alternatives (Jan '90 - Dec '09) |
| Allocating towards alternatives may decrease risk |
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Source: Pertrac Financial Solutions
Past performance is not an indication of future results. Index returns are provided for illustrative purposes only to demonstrate the use of diversification among asset classes using broad-based indices of securities. Returns do not represent an actual investment. Actual investment returns would vary. Indices do not have costs, fees, or other expenses associated with their performance. Therefore, actual investment returns would be lower. In addition, securities held in an index may not be similar to securities held in an actual account. It is not possible to invest directly in an index.
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Annualized Return: Annualized return, or "average annual return," describes the return gained, on average, each year of a multi-year period rather than a cumulative return.
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Annualized Standard Deviation: Risk as measured by the variability of performance. The higher the standard deviation, the greater the variability (and therefore the risk) of the fund or index.
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Barclays Capital Aggregate Bond Index: The Index represents securities that are SEC-registered, taxable, and dollar denominated. It covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
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HFRI Fund of Funds Composite Index: The HFRI Fund of Funds Composite Index is an equal-weighted index that includes both domestic and offshore fund of funds. Funds included in the index invest with multiple managers through funds or managed accounts. The fund of funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies.
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S&P 500: Standard & Poor's 500 Total Return Index. Periods greater than one year are annualized. An index consisting of 500 stocks chosen from market size, liquidity and industry group representation, among other factors, the S&P 500 is designed to be a leading indicator of U.S. equities, and it is meant to reflect the risk/return characteristics of the large-cap universe.
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60/40 Portfolio: Hypothetical investment where 60% of the portfolio is invested in S&P 500 and 40% is invested in the Barclays Capital Aggregate Bond Index.
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