The Benefits Of Non-Correlated Alpha
The Benefits of Non‑Correlated Alpha
In Q1 2022, 60/40 portfolios suffered as both stocks and bonds sold off and the power of bonds as a diversifier (and, accordingly, a means of reducing portfolio volatility) deteriorated. Meanwhile, record inflation serves to exacerbate the issue and erode real returns. These challenges indicate an increased need for alternatives that offer both diversification to equities and bonds as well as compelling long-term returns.
IN 2022, MANY INVESTORS FACE SEVERAL KEY CHALLENGES
1) Diminishing Returns of a 60/40 Portfolio
In Q1, both equities and bonds posted negative returns. While the trajectory for equities is marked with uncertainty, bond return potential has diminished as historically low yields translate to lower coupon payments, negative real yields, and less scope for price appreciation.
2) Positive Stock/Bond Correlation
Equity/bond relationships are not static, and there have been extended periods of positive stock/bond correlation. Today, historically low yields mean that the protective character of bonds is in jeopardy and investors may see positive correlations between stocks and bonds.
3) Volatility and Market Uncertainty
Given geopolitical developments and macro imbalances, markets have exhibited heightened volatility in recent months alongside an increased potential for market shocks. Should the equity hedging benefits of bonds diminish, the ability to manage portfolio volatility will become more challenging.
4) Inflation Sensitivity
CPI reached a 40-year high of 8.5% in March. Elevated inflation presents a significant risk to stock/bond portfolios in terms of asset valuation, erosion of real returns, and positive correlation. When inflation rises, real yields decline alongside the market price of bonds.
Inflation can also weigh on stocks when combined with hawkish monetary policy, as we saw in the 1970s, potentially leading to simultaneous losses in stocks and bonds and positive correlations.
THE ROLE OF ALTERNATIVES
1) ENHANCE RETURNS
Ideally, investors should seek alternative strategies with positive long-term return and low correlation characteristics, which offer the potential to enhance the risk-adjusted returns of a broader investment portfolio.
2) PROVIDE DIVERSIFICATION
Many alternatives have low correlation to stocks and bonds, with the ability to profit in both rising and falling markets with no inherent bias and the potential to provide equity crisis returns.
3) REDUCE VOLATILITY
Diversification properties result in the potential to reduce the overall volatility and drawdowns of a broader investment portfolio. Active risk management approaches can help navigate market volatility and changing market dynamics.
4) INFLATION AGNOSTIC
Many alternatives can perform well in inflationary or noninflationary regimes and can capitalize on increasing commodity prices during inflationary periods.
WHERE CAN INVESTORS TURN TO FOR DIVERSIFICATION? NOT ALL ALTERNATIVES ARE CREATED EQUAL
Many investors seek diversification through alternative strategies. However, not all alternatives provide the desired portfolio
diversification benefits. Diversification benefits vary significantly across styles, and many strategies have positive correlation during equity down markets.
Correlation of Alternatives to Equities
Based on Monthly Data from January 1990 through March 2022*
Q1 2022 CASE STUDY
In Q1 2022, markets experienced a trifecta of a selloff in equity and bond markets, heightened market volatility, and elevated inflation, making it a difficult start to the year for many investors. From an asset allocation perspective, investors should consider allocations to alternative strategies that, ideally, have positive long-term return potential and diversifying characteristics during difficult equity environments. Importantly, diversification should be a constant rather than a reaction to short-term market conditions.
*Alternative strategies above are represented by their respective HFRI indices. Data is presented from inception in January 1990 with the exception of the Credit and Trend Following indices, which are available from January 2008. For purposes of this presentation, we show broad hedge fund indices as categorized by HFRI, but our selection is not meant to be an exhaustive representation of all potential alternatives. Other investment strategies, including private equity, real estate, and venture capital, among others, are often considered to be diversifiers to traditional stock and bond portfolios but are not shown here due to limitations on the availability of a representative index or other constraints or considerations.
LONG-TERM BENEFITS
Market conditions continually change, and the best way to construct a portfolio resilient to changing market regimes is through proper diversification. Allocating to strategies that have low correlation to equities and bonds can be a valuable portfolio construction tool with the potential to lower the volatility and soften the drawdowns of an overall portfolio while adding to returns over the long run. These strategies are meant to complement – rather than compete with – traditional investments. And while it is unreasonable to expect any strategy to perform well at every discrete point in time, holding the diversifying alternatives as a long-term, strategic allocation in a diversified investment portfolio offers the potential for significant benefits.
Below, we show the impact of allocating to macro and trend-following strategies, which are widely regarded as effective diversifiers within an investment portfolio.
THE BOTTOM LINE
- In the current investment landscape, there is a need for alternatives that can offer both positive returns and diversification to both equities and bonds.
- Diversifying strategies such as macro and trend following offer significant long-term return and diversification benefits, with the flexibility to capture moves across a variety of market environments.
- Allocating to diversifying strategies as a strategic, long-term investment within a diversified portfolio can potentially enhance risk-adjusted returns and reduce overall volatility and drawdowns.
IMPORTANT DISCLOSURE
LEGAL DISCLAIMER
Source of data: Graham Capital Management (“Graham”), unless otherwise stated
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Tables, charts and commentary contained in this document have been prepared on a best efforts basis by Graham using sources it believes to be reliable although it does not guarantee the accuracy of the information on account of possible errors or omissions in the constituent data or calculations. No part of this document may be divulged to any other person, distributed, resold and/or reproduced without the prior written permission of Graham.
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