Liquid Alternatives – Assessing their Recent Performance & Diversification Benefits

“Alternative Investments” is a category that covers a wide range of different strategies and portfolio construction techniques, many of which make similar claims: they offer returns that are uncorrelated with traditional stock & bond strategies, help reduce portfolio volatility, and can improve long term performance when paired with those traditional strategies.  With the volatility we’ve seen in equity markets the last few years, I thought this would be a good time period to examine how they did.

Last year US Equities, as measured by Vanguard’s Total US Stock ETF (VTI), experienced their second 20%+ drawdown in only three years with the other coming in late 2018.  From 9/20/2018 through 12/24/2018, US Stocks fell by 21%, and more recently had a nearly 35% drawdown from 2/19/2020 through 3/23/2020 due to the COVID-19 related selloff.   The proximity of these sharp drops is actually quite rare as 20% drawdowns have occurred only once about every ~7 years on average going back to 1950 (Short History of US Stock Market Corrections & Bear Markets ).  So I thought that this 3 year period from 2018-2020 would be good one to assess those various liquid alternative strategies by answering the following two questions:

1. How did each strategy perform during those sharp equity selloffs?
2. How did each strategy affect the volatility and performance when added to a traditional 60/40 allocation for the 3-year period from 2018-2020?

To do that I started with five of the alternative sub-categories as defined by Morningstar, and selected one of the more popular funds by AUM within each of those categories to see how they performed.  Those five sub-categories included Market Neutral, Multi-Alternative, Managed Futures, Equity Long/Short, and Bear Market (also referred to as ‘tail risk’ funds).  Below I’ve listed the funds, their respective categories, how they performed during those two equity drawdown periods I mentioned, and their average annual performance for the 3 year period:

My biggest takeaways after looking at the performance of those strategies:

• Despite the volatility, core bonds still performed better than all but one of the alternative strategies for the 3-year period with a 5.4% avg annual return.
• The Equity Long/Short strategy performed the best for that 3-year period, but experienced sharper equity-like drawdowns (-17.7% & -14.7%) during those selloff periods highlighting the elevated risk profile those strategies can exhibit.
• The two categories that fared the best during those drawdown periods, Managed Futures & Bear Market, both had the worst overall performance for the full 3-year period.
• The PIMCO Short Fund (PSTIX) is the only fund that had positive returns during both selloff periods, but that is the only strategy designed to do so. Bear Market Funds have net short interest, and actually have a negativeexpected return in normal environments as evidenced by the -12.8% avg annual performance for that fund for the period.  These funds act as a form of portfolio insurance that only appreciate during equity declines, and are a drag on performance in normal environments.

The next thing I wanted to look at was how each of these strategies affected portfolio volatility and performance when added to a traditional portfolio of stocks and bonds.  So I created a backtest for that same 3-year period (2018-2020) for a global 60/40 portfolio using the iShares MSCI ACWI ETF (‘ACWI’) & Vanguard Total Bond Market ETF (‘BND’), and then created 5 hypothetical portfolios with 10% allocated to each of those 5 alternative strategies taking 5% from both stocks and bonds.  The below chart shows the volatility (measured by standard deviation), Sharpe Ratio (risk-adjusted performance measure), CAGR, ending values, and worst 3-month period for each of those 6 hypothetical portfolios assuming a $1MM initial investment with annual rebalancing.

All but one of the 5 portfolios with 10% allocated to a liquid alt fund underperformed the normal 60/40 portfolio, and the one that didn’t, essentially matched its performance.  From a risk adjusted perspective, two styles provided a slightly better Sharpe ratio.  All of the alternative funds did reduce portfolio volatility slightly, but for most of them, that came at the cost of overall underperformance.

Coming into that 3-year period, the S&P 500 had just come off a year where it returned 21.7% in 2017 and the 10-year treasury yield was around 2.7%, which seems attractive now but was still very low from a historical perspective.  If you had told me US Equities would go on to see two separate 20%+ drawdowns over the next 3 years, I would have sworn that these alternative strategies would have added value to a traditional portfolio, but that wasn’t the case.

That’s not to say these strategies never will add value as this has been a unique environment and 3 years is certainly not the largest sample size.  Even the best strategies can underperform for extended periods of time, and still serve a purpose within a diversified portfolio. But I do think it is a good illustration that when strategies are sold to offer “uncorrelated returns”, that they can also come at the cost of near term underperformance.

Andrew Gibson, CFA
Vice President, FSTC

The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only.  FSTC does not offer tax, legal, or investment advice, professional counsel should be sought for tax or legal advice.