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Diversification, Correlation and Alternatives in a Scary Market

When the stock market is volatile, bearish or otherwise scary, reallocating into safer investments might help you sleep at night, but it probably won’t help your portfolio grow as much as you would like. At a time like this, diversifying into alternative assets can be a smarter portfolio strategy than (or in addition to) seeking shelter.

Thanks to the Jumpstart Our Business Startups (JOBS) Act of 2012, all investors, regardless of income or net worth, have opportunities to invest in alternative assets via equity crowdfunding. Title III of the JOBS Act created “true” equity crowdfunding, where all investors can invest in seed-stage startups and growing private companies on crowdfunding portals and broker-dealer platforms starting in May 2016. Title IV  of the JOBS Act expanded the Regulation A exemption in 2015, and all investors can participate in Regulation A+ offerings, as they are known (also called mini-IPOs), via offering platforms. Everyone can be an angel investor.

Most individuals should limit their investments in alternatives—angel investments, venture capital, private equity, hedge funds, tangible assets, precious metals, etc.—to 5 percent or 10 percent of their investment portfolios, according to conventional wisdom.

Diversification and Portfolio Strategy

Why would anyone—anyone motivated primarily by financial returns, that is—invest in risky private securities if they can, more easily and with greater liquidity, invest in less risky public securities? Because taking such a risk generally gives investors an opportunity to earn commensurately higher returns.

The riskiness of investing in private securities should not be judged in isolation, though. You should weigh the riskiness of an investment, or a particular class of investments, in terms of how it affects the overall risk in your entire investment portfolio. By adding diversification to your portfolio, private securities (which can appear risky in isolation) can potentially reduce overall portfolio risk when done judiciously.

Diversification is not putting all your eggs in one basket. As a worst-case example of the dangers of failing to diversify, look at the many employees of Enron who invested their 401(k) funds back into their employer. In 1999 and 2000, investing in Enron seemed like a smart bet. But putting all their eggs in that basket resulted in financial catastrophe for Enron investors who failed to diversify. As a result of Enron’s bankruptcy, Enron employees not only lost their jobs, but lost $1.2 billion in retirement funds. Enron retirees lost $2 billion in pension funds. (In the year before the crash-and-burn, Enron executives received bonuses totaling $55 million and cashed in $116 million in Enron stock.)

Diversification means investing in different asset classes (stocks, bonds, mutual funds, money markets, real estate, etc.), in different sectors of the economy (energy, utilities, healthcare, manufacturing, retail, natural resources, media, services, technology, etc.), maybe in global markets as well as U.S. markets. Diversification assures you that if one sector of the economy suffers, your entire portfolio won’t be a disaster. If you were invested heavily in technology stocks in 1999, for example, the dot-com bust could have wiped you out.

Alternatives and Non-correlation

In addition to the asset classes mentioned above, accredited investors have had the privilege of investing in alternative asset classes, further diversifying their risks. Alternatives include private equity, venture capital, angel capital, hedge funds and tangible asset funds (which invest in farmland, machinery and equipment, natural resources, etc.). Now non-accredited investors have massively broader access to angel capital markets via Titles III and IV, as well as intrastate equity crowdfunding [pdf] in at least 26 states and the District of Columbia.

Alternative assets offer investors a special kind of diversification, known as non-correlation. Alternatives typically do not rise and fall with the broader markets. When the country goes through a general economic downturn and most mainstream asset classes level off or fall in value, non-correlated alternatives will tend not to follow the mainstream, but can maintain their own momentum or otherwise move independently of macroeconomic pressures.

Certain kinds of hedge funds, for example, are positioned to earn a positive return even when most stocks and bonds are losing value. By taking offsetting short and long equity positions, these hedge funds can make money in falling as well as rising markets. In 2013, when the public stock market indexes soared (the S&P 500 gained about 16 percent), hedge funds posted lackluster gains (about 7 percent). But in the mini-recession of 2000 through 2002, when the S&P fell an annualized 17 percent, hedge funds returned a positive 7 percent. And in 2008, the heart of the deep financial crisis, the S&P 500 was down a whopping 38 percent, while hedge funds fell only 19 percent (data from Preqin and HFRX). Thus, hedge funds exhibit a lack of correlation with the general market, effectively diversifying portfolio risk.

Likewise, venture capital has exhibited a lack of correlation with public stocks. Morningstar researchers found in 2002 that “the correlation coefficient between VC and public stocks is estimated to be 0.04 percent,” which is essentially zero. This non-correlation does not have the same basis as hedge funds—VC funds do not take offsetting long and short positions. But share values of venture-backed startups and early-stage companies do not tend to drift upward and downward in response to macroeconomic forces that affect public stock values.

We could not find research on correlation measurement between angel capital and public securities. But because of the similarity of angel and venture capital stages and deal structures, the non-correlation characteristics should be similar as well—assuming sufficient diversification within the angel investment portfolio. In other words, angel investors likely have a similar experience as venture capital funds and hedge funds, in that they do better than the overall market during periods of decline and also do reasonably to very well when broader markets are in the black.

Before 2016, as a practical matter, only accredited investors could invest in most alternative asset classes. Thanks to the JOBS Act, now non-accredited investors can diversify into one alternative asset class, angel capital, via equity crowdfunding. So diversification into a non-correlated asset class is now possible for everyone.

 

— David M. Freedman has worked as a financial and legal journalist since 1978. He is a frequent contributor to Accredited Investor Markets, and participates as a panelist and moderator in various Financial Poise Webinars for investors. Matthew R. Nutting is a corporate lawyer with Coleman & Horowitt in Fresno, CA. He advises entrepreneurs, investors, and intermediaries on all aspects of rewards- and securities-based crowdfunding. Freedman and Nutting are the authors of “Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms” (Wiley & Sons, 2015).

About David M. Freedman

David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…

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