skip to main content
Close Icon We use cookies to improve your website experience.  To learn about our use of cookies and how you can manage your cookie settings, please see our Cookie Policy.  By continuing to use the website, you consent to our use of cookies.
Global Search Configuration

In the aftermath of the Credit Crisis, diversification has come under the microscope. Portfolios that were traditionally considered diversified could not withstand the global reach of the crisis and protections failed when they were needed most. The past decade has proven that simply adding foreign investments to a portfolio does not equal diversification.

 

Below we take a deeper look at diversification and the different alternative investments available to retail investors to determine the effect they have on a portfolio and whether they are doing their intended job or not.

 

Before we get started it’s important to disclose the asset classes and corresponding indexes used to run the mean variance optimization analysis. Table 1 displays the basic asset classes, in addition to the three alternative assets used – real estate investment trusts (REITs), commodities, and long/short funds.

 


 Table 1

The process for constructing a risk/return optimized portfolio begins with creating a mix of investments with low correlations.  Since investors are risk averse, it’s important to realize that correlations often fluctuate during a market cycle, and particularly increase during a crisis compared to long term averages. Figure 1 shows the correlations between different asset classes from January 1997 to September 2016, which are noticeably lower than the correlations for the same asset classes during the credit crisis (Figure 2).


 Figure 1

 


 Figure 2

 

The above correlation matrices provide insight into why a diversified portfolio based on historical standards fell prey to the Credit Crisis and why it’s imperative to broaden your use of alternatives when looking for enhanced diversification.

 

In addition to knowing how the different asset classes correlate to one another, it’s equally important to understand where the risk in the portfolio is coming from so you know the type of hedging strategy needed. As shown in figure 3, a typical 60/40 portfolio is nearly perfectly correlated to an all equity portfolio, while this same 60/40 portfolio has very low correlation to interest rate movements (10 yr. Treasury) and is negatively correlated to changes in inflation (CPI).


 Figure 3 – 60% S&P 500 / 40% Barclays U.S. Aggregate portfolio is rebalanced  annually.

 

With the above knowledge in hand, we can move forward with constructing an efficient frontier to determine the effect alternatives have on a traditional asset allocation consisting of basic asset classes. To determine the forecasted returns for the core asset classes, we use the Black Litterman forecasting model, whereas for the alternative asset classes we use the historical returns (Jan 1997 – Sept 2016).

 

As you can see in figure 4, by adding the three alternatives listed above to an allocation case which includes the basic assets, the efficient frontier shifts to the northwest, which represents higher returns and lower risk. This is the intended result of adding alternatives to an allocation.

 


 Figure 4 – Past performance is no guarantee of future results.  For illustrative  purposes only.

Figure 4 also displays hypothetical portfolios, composed of the basic assets (blue font) as well as portfolios including alternatives (olive font). Table 2 below provides the details of each portfolio.  Focusing on hedging against equity risk, we added a 15 percent allocation to alternatives, split evenly across the three alternative investments, while reducing the equity allocations of each portfolio. As expected, adding alternatives increases diversification by reducing the expected risk, however, adding alternatives results in lower expected returns for each portfolio.


 Table 2 - – Past performance is no guarantee of future results.  For illustrative      purposes only.

Taking this a step further, we can look at the individual alternative investments to determine if they are adding value to the portfolios. As you can see in figure 5, the commodity asset has a very low forecasted return while its risk is in line with U.S. equities. By removing the five percent commodity allocation from the portfolios, the return/risk characteristics for the portfolios become more attractive (see table 3).

 


 Figure 5 – Past performance is no guarantee of future results.  For illustrative  purposes only.


 Table 3 – Past performance is no guarantee of future results.  For illustrative purposes  only.

When creating a portfolio for your client which aims to reduce unsystematic risk via diversification, alternative investments need to be considered. Keep in mind that not all alternative investments are created equally, and that each alternative provides unique benefits to a portfolio. It’s important to look at all factors including what risk(s) you are trying to protect against as well as how correlations fluctuate during different market cycles. 

Recommended Articles

  • PSN Enterprise - Separate Account Analytics Software, Zephyr...

    Ryan Nauman's Weekly Recap 02.18.20

    By Ryan Nauman 18 Feb 2020

    The week ahead is full of housing data, from home builders' confidence to existing home sales. The housing market has recently stabilized, in large part due to a strong labor market and low mortgage rates, however, for the sector to completely rebound, inventory needs to pick up, so the release of housing starts and building permits data should be widely watched. Walmart is the headline earnings release, while providing insight into the consumer after the soft retail sales number last week. Is the consumer still willing to shoulder the economy, or are they losing some momentum? Read more from Ryan Nauman's Weekly Recap and subscribe to have it delivered to your inbox each week!

    Topics Industry News

  • PSN Enterprise - Separate Account Analytics Software, Zephyr...

    Ryan Nauman's Weekly Recap 02.10.20

    By Ryan Nauman 10 Feb 2020

    Despite the Q4 earnings season slowing down, there remains some big-name companies who are on deck to release earnings this week including: Cisco Systems, Applied Materials, and Nvidia. While it might be a quiet week for earnings, the week ahead is full of important economic data releases, including small-business optimism, inflation, and retail sales. Read more from Ryan Nauman's Weekly Recap and subscribe to have it delivered to your inbox each week!

    Topics Industry News

  • PSN Enterprise - Separate Account Analytics Software, Zephyr...

    Ryan Nauman's Weekly Recap 02.03.20

    By Ryan Nauman 03 Feb 2020

    Based on how this week finished, most investors will be focusing on the coronavirus outbreak and its growth. However, the week ahead has some big earnings and economic data releases that are worth monitoring. The manufacturing PMI and ISM manufacturing indexes are top of the list, as the sector has stabilized recently and will be an important sign on the overall health of the economy. The end of the week includes the ever-important jobs report. As for earnings releases, Alphabet, Ford, Disney, and GrubHub are some of the names I will be watching closely. Read more from Ryan Nauman's Weekly Recap and subscribe to have it delivered to your inbox each week!

    Topics Industry News

;

Any questions? Speak to a specialist

Would you like to request sample data or analysis from Informa Financial Intelligence? 

See how our tailored solutions can help you gain a competitive advantage: