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alternative assets in a bear market

When Stocks Decline, Alternative Investments May Help (Part 1)

With Bear Market Approaching, Diversification an Attractive Option

Someday you may be asked: “Where were you on March 9, 2009?” For market historians, that day marked the bottom of the Great Recession: the S&P 500 had just sunk below 700 for the first time in 13 years. Goldman Sachs warned investors that the S&P could fall as low as 400. The months-long financial panic that had gripped the world had, by that date, subtracted trillions of dollars from individual and institutional portfolios.

Almost 10 years later the S&P 500 closed at 2,731.61 on February 6, 2019, slightly down from its 2018 high – a major signpost for the longest-running bull market in history.

So with all of that good news as background, when will the current bull market come to an end? A bear market is one in which market indices such as the S&P 500 and Dow Jones Industrial Average decline at least 20% over a two-month period or longer. Since 1926, the stock market has been through 19 bear markets, with one on average nearly every five years, according to Kiplinger.

Bear Markets and Diversification

No one knows, of course, when a bear market will occur.  Maybe stock prices will continue rising short term, but being prepared for a potential drop by diversifying your portfolio could help prevent major losses. The 16 bull markets since 1926 have lasted an average of 3.8 years, so the current bull market is well above average, lasting longer than the bull markets of 1949 to 1956, 1974 to 1980 and 1990 to 2000 (which lasted 9.4 years).

Even in stable years, investors should expect sudden periods of volatility. Pullbacks by as much as 5% are quite normal. Historically, though, the frequency of corrections increases as a bull market ages, so recent market volatility could continue. That’s why the present moment may be a good time to explore diversification opportunities that could offer a way to temper the impact of sudden downdrafts on a portfolio.

[Editor’s Note: For greater insights on how mainstream alternative investments have evolved over the years, check out John Drachman’s “Beyond the Fringe: The Evolution of Mainstream Alternative Investments.”

Alternative Investments for Diversification

Jeffrey Kelley, the senior vice president of Equity Institutional, explains that investors should periodically review their investment diversification.

“To reduce portfolio volatility, the financial advisers I talk to typically encourage their clients to review their portfolios periodically to see if their diversification strategy still aligns with their investment objectives,” Kelley said.

In 2018, PPB Capital Partners surveyed 250 Registered Investment Advisors who had at least $500 million in assets under management (AUM) to see how they planned to create a softer landing for their clients in the event of a major market pullback. The results showed that these advisers planned to tap alternative investments as a way to help hedge against potential market downturns in the year ahead:

  • 45% of advisers said they increased allocations to alternatives in 2018, while 48% said they maintained their current allocation.
  • 73% of advisers said they planned to increase their clients’ alternative investment exposures by up to 25%.
  • Among alternative investment preferences, private equity led the way, followed by private credit and lending, real estate, hedge funds and venture capital.
  • 44% cited their primary reason for using alternative investments was for non-correlated returns, while 31% said they were looking to enhance performance and another 20% cited reduced risk as their primary motivation to shift to alts.

The impact of asset allocation on volatility and returns has been studied for decades. Kelley points to a study that showed how diversifying among a variety of asset classes – and keeping a steady allocation through rebalancing – accounted for 93.6% of the variation in the quarterly returns of the 91 large U.S. pension funds for the period 1974 to 1983.

[Editor’s Note: To learn more about the many kinds of alternative assets available, check out our two-part webinar series: “Alternative Assets Part 1: Investing in Venture Capital, Private Equity, and Hedge Funds” and “Alternative Assets Part 2: Investing in Real Estate and Other “Hard” Assets”]

To guide their clients, Wells Fargo Investment Institute published a bear market action list with five steps:

  1. Revisit asset allocation
  2. Rebalance regularly
  3. Broaden exposure to risk-mitigating assets
  4. Look for tactical opportunities late in the business cycle
  5. Be active and smart, particularly where including alternative investments is concerned.

As a counterpoint to rising stock prices, they urged investors to better understand the role alternative investments might play in a portfolio. Illustrating the performance of a 50/50 blend of hedge funds and private equity versus a fixed income portfolio and a developed market equity portfolio, the alternative option helped manage volatility and reduced downside risk while still participating in up markets.

As the current business cycle gradually ages, alternatives with inflation-resistant properties have shown merit, too. Over the course of 2017, hedge funds, private equity and REITs demonstrated their capacity to reduce risk and still deliver an attractive level of risk-adjusted return.

According to Forbes’ Javier Estrada, the enduring luster of precious metals like gold can also play a role in buffering a portfolio against downward volatility. Citing his research for the Journal of Wealth Management, Mr. Estrada demonstrated that a 20% portfolio allocation to gold would have substantially lowered risk during both the high-tech sell-off in 2000-2002 and the global crisis of 2007-2009.

[Editor’s Note: This is part one in a two part series. For further insights on the role of alternative investments, check back tomorrow for “When Stocks Decline, Alternative Investments May Help (Part 2).”

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About John Drachman

As an award-winning writer, John developed marketing communications initiatives for dozens of money managers for more than 20 years. John combines editorial skill and marketing knowledge in helping advisors, money managers and service providers to grow and retain assets.

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