Using alternatives to help improve the risk-adjusted returns of a 60/40 portfolio

The decade prior to 2022 has been favorable for equities and bonds with underlying performance drivers such as ultra-low interest rates, low inflation, and massive monetary stimulus. However, as a potentially new macroeconomic regime takes hold, which we believe may be characterized by higher and more uncertain inflation, higher interest rates, and traditional asset class returns in line with long-term averages, allocating to alternative strategies within a diversified portfolio has merit. As investors increasingly look toward allocating to alternatives, effectiveness may rest on understanding a strategy’s performance blueprint and how this may affect allocation decisions.

Understanding an alternative investment strategy’s performance blueprint

The advantages of combining low correlated strategies in an investment portfolio rest on the fact that when one strategy does poorly, another may do well. The aim of this approach is to increase risk-adjusted return potential and help protect portfolios through periods of high volatility that not only erode gains but also erode investors’ confidence.

However, while low correlation may be key, it’s not the only way to potentially enhance risk-adjusted returns. Correlation, in combination with both risk and return, comprises three levers that determine the effectiveness of an alternative strategy within a portfolio.  

Return, risk, and correlation constitute distinct levers in the alternative strategies tool kit

To illustrate the effect of different levers, consider portfolios on a risk/return or efficient frontier spectrum. The efficient frontier plots the portfolios that tend to provide the highest achievable potential returns for a given level of risk. For most investors, the goal is to shift the efficient frontier up and to the left. In other words, to pursue more potential return for a given amount of risk. 

Adding low correlated investment strategies may be an effective way of pursuing this as they offer a direct path to potential higher risk-adjusted returns, as depicted in line A above. However, a strategy that offers potentially higher returns for the same amount of risk, shown by line B, also has the potential to improve a portfolio’s risk-adjusted return despite its high correlation. Similarly, a highly correlated strategy that seeks to offer the same amount of return, but with lower risk, as shown by C, also has the potential to improve risk-adjusted returns. The key to comprehending the potential effectiveness of alternative strategies is recognizing that risk and return are levers that may contribute positively to a portfolio, even if low correlation isn’t always present.

Granted, lines B and C in this illustration are extremes. It’s rare for a strategy to offer more return for the precise level of risk or the exact same level of return for less risk; however, these examples demonstrate that alternative investments can use all three levers—in varying degrees—to potentially improve risk-adjusted returns. Some alternative strategies may offer a relatively high potential risk/return profile and a moderate correlation benefit. Other strategies may offer less return, but also less potential risk, while adding diversification benefits. The profile created by a particular strategy’s combination of risk, return, and correlation, relative to a traditional portfolio, is what we refer to as an alternative strategy’s performance blueprint—this is key to understanding how to structure an allocation to alternative investments effectively within a portfolio.
 

Using alternative investments to help improve the risk-adjusted returns of a 60/40 portfolio

For most investors who are aiming to improve the risk-adjusted returns of a 60/40 portfolio, diversifying across alternative strategies with varying performance blueprints is a tactic that has merit. This constitutes a multistrategy approach that offers several benefits.

A larger component of the overall return profile of alternative strategies is generated from alpha—often more so than in traditional investments. As a result, there's the potential for greater dispersion of returns among alternative managers, which tends to increase the likelihood of investor dissatisfaction if an inadequate manager has been selected or if only one manager is selected. A multistrategy approach diversifies manager alpha, and, as a result, returns are less reliant on a single manager’s outperformance. This helps to reduce manager concentration risk.

Second, applying a multistrategy approach provides the potential to gain diversified exposure to a range of strategies and managers that not only have lower correlations to traditional asset classes but also to one another. This is significant as it’s impossible to predict every condition under which individual alternative strategies will do well or do poorly.

For example, investors are often drawn to market neutral and managed futures strategies for their low correlation to equities (0.30 and -0.28, respectively), but of key importance is that these strategies also have a markedly low correlation to each other (0.11).  Note that this is significantly greater diversification than is typically gained among traditional asset classes (e.g., United States versus international stocks).¹  This means that in environments in which managed futures struggle to provide adequate risk-adjusted returns, market neutral may be able to do so, and vice versa.

An essential element in the effective use of alternatives is the inclusion of diverse strategies that may perform well at different times within a portfolio. An approach of building a multistrategy allocation ensures diversification across managers and strategies with different performance blueprints.

The question that follows is how to fund a multistrategy approach. As with many aspects of investing in alternatives, generalizations are difficult and optimal outcomes vary by client; however, one approach may be to fund an allocation equally from both equities and fixed income. Expectations are that this may help to reduce a portfolio’s overall risk. Investors aiming to maintain a volatility profile on par with a 60/40 portfolio may want to consider funding more than 50% from fixed income, depending on the specific alternative strategies selected.

A multistrategy approach has merit for pursuing better risk-adjusted return potential using alternatives broadly. However, some investors may have specific portfolio objectives that warrant a more precise allocation and funding strategy.

For instance, an investor may want to reduce specific risks, such as equity, credit or duration. These risks may be targeted and reduced by selling equities, credit, and high-quality bonds, respectively, and allocating to alternative strategies. Financial professionals may download “How to structure an allocation to alternative investments” to read more about using alternative investments to pursue specific portfolio objectives.

Making alternatives work for you

The alternative investment landscape is diverse and complex with a range of registered alternative vehicles that offer varying degrees of liquidity aimed at individual investors. Understanding the expected blueprint for alternatives can help investors and financial professionals apply a framework to assess the merits of allocating to different strategies within an overall diversified portfolio. In addition to choosing the most appropriate strategy to incorporate into a portfolio, determining how to fund an allocation—specifically whether to decrease equity or fixed-income exposure—may affect the outcomes associated with allocating to alternatives. As such, partnering with an experienced investment firm is key to gaining robust insight when navigating the alternative investment landscape.

Find out more about investing in alternatives.

Diversification does not guarantee a profit or eliminate the risk of a loss.