As noted in part 1, the impact of asset allocation on volatility and returns has been widely debated, but a landmark study showed that diversifying among a variety of asset classes and keeping a steady allocation by rebalancing accounted for 93.6% of the variation in the quarterly returns of the 91 large U.S. pension funds included in the study for the period 1974 to 1983.
How assets are allocated, of course, also matters.
While the studies cited in Part 1 show that historically asset allocation has helped reduce volatility, a traditional allocation of stocks, bonds and cash equivalents may not provide the asset diversity needed to manage risk adequately today.
Historically, stock and bond prices have generally moved in opposite directions, so a loss in one asset class could be balanced to some degree by a gain in the other asset class. QE, though, not only boosted stock prices, it also boosted bond prices, which typical rise when interest rates drop.
In fact, many previously non-correlated asset classes rose in tandem. As the chart shows, international stocks – including emerging market stocks – U.S. investment-grade and high-yield bonds and cash all moved in the same direction as U.S. stocks during the 2008 and 2009 global recession (U.S. Treasury bonds were an exception), and the correlation between U.S. stocks to international stocks and high-yield bonds jumped to nearly 90%.
Investors have been enjoying gains in a wide variety of assets; will they also experience losses in the same asset classes if the stock market changes direction?
At some point, when the Fed determines that the economy is sufficiently recovered, it will raise interest rates. No one knows for certain what will happen when rates rise, but typically when interest rates increase, bond prices fall. Based on the “taper tantrum” experience cited earlier and the current high valuation of stocks, stocks and bonds could fall concurrently when the Fed raises rates.
Fed Chair Janet Yellen said recently she expects the Fed to increase interest rates before the year ends.
During the current bull market, alternative investments have largely been outperformed by stocks and bonds. Many alternative investments have either no correlation with stocks or bonds, little correlation or negative correlation. If an asset class has a negative correlation with stocks, it typically will drop in value when stocks rise in value; conversely, it will likely rise in value when stocks drop.
Having assets with negative correlation to each other creates a hedge. When the price of one drops, the investor has downside protection, as the price of the other asset should rise. So the alternative assets that have fallen in price as stock prices have soared may be the assets to buy today, since they should rise when stock prices fall.
There are many different alternative assets to choose from. By its broadest definition, alternatives include all assets that are neither stocks nor bonds. Private equity, including investments made through crowdfunding platforms, is an example. Many, though, think of alternative assets as hard assets or real assets; tangible items that hold inherent value, such as real estate, currency and commodities.
Gold is an alternative that people have been investing in for 2,700 years. Corn and grain, farmland, timber and managed futures are all alternative assets. So are art, antiques, wine and other collectibles. There are also a variety of alternative strategies, which revolve around a specific approach to investment, rather than specific assets. A few examples include long/short, market neutral and opportunistic investment strategies.
While alternatives are often used to diversify a portfolio and manage risk, they are also sometimes used for their potential to boost return – many hedge funds, for example, leverage their investments, which can result in higher returns or higher losses for the investor.
“Helping financial professionals and their clients invest in alternatives like real estate, debt, and private equity is something we have been doing for 40 years,” Kelley said. In many cases, an alternative custodian is needed to successfully provide custody for an alternative investment.”
Many alternatives are available only to accredited investors. Historically, accredited investors often invested in alternatives through hedge funds, but in recent years other investment options have proliferated. Some provide lower fees and greater liquidity than hedge funds.
Quoting a 2014 RIA Database Survey, Julie Cooling of Forbes reported that “78% of financial advisors believe that alternatives are a critical and important part of asset allocation.”
To manage risk, it’s important to have enough knowledge of alternative investments to understand how to use them to diversify. It’s also important to recognize that alternative investments can be volatile.
Gold, for example, soared in price after the financial crisis, but fell back to its lowest price in four years, before recently making a comeback. Investments in energy through master limited partnerships (MLPs) have provided among the highest returns for investors in recent years, but, with oil prices dropping, such investments were recently experiencing significant losses.
Experienced advisors will be able to explain how to use tax advantages when investing in alternatives, such as by investing through an IRA, according to Jeff Kelley, the chief operating officer and senior vice president at Equity Institutional. Those who meet income requirements can deduct their contributions to a traditional IRA and it also offers tax-deferred growth – you pay taxes on your investment gains only when you make withdrawals. Using a Roth IRA, taxes are paid on the amount contributed, but you never have to pay taxes on investment gains.
Most accredited investors exceed the income guidelines and may assume they do not qualify for IRA investing, but there are many ways that even accredited investors can qualify to invest in IRAs, according to Kelley:
Accredited investors interested in alternatives may feel overwhelmed trying to develop knowledge about a wide variety of asset classes; they may instead choose to focus on a distinct set of alternative investments, such as real estate or precious metals.
The stock market may continue breaking records in 2015 – but, like housing prices – stock prices will not continue going higher indefinitely. No one knows when they will fall, but it’s best to be prepared for when they do. Investing a portion of your portfolio in alternatives may help.
Editor’s Note: To learn more about other options for the accredited investor, we suggest this webinar.
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