Swedroe: Correction Protection In Liquid Alts

February 26, 2018

Late January through early February saw the global equity markets undergo a “correction.” From the close on Jan. 26, 2018 to the close on Feb. 9, 2018, the Vanguard S&P 500 ETF (VOO) lost 8.7%. The Vanguard FTSE Developed Markets ETF (VEA) experienced an even greater loss of 9%. And the Vanguard FTSE Emerging Markets ETF (VWO) lost even more, dropping 10.1%.

A globally diversified portfolio, weighted approximately by market cap (U.S.: 1/2; developed markets: 3/8; emerging markets: 1/8) would have lost 9.0%. Even the Vanguard Total Bond Market ETF (BND) lost 1.3%, reminding investors that stocks and bonds can experience losses at the same time.

Correction Protection

Recently, I’ve written about four liquid alternatives I believe investors should consider including in their portfolios. How did they perform during this period? Before reviewing the results, let’s briefly review some reasons I recommend investors consider these alternatives.

The first is that the risk of traditional stock and bond portfolios is dominated by the single factor of market beta. Even market-cap-weighted 60% stock and 40% bond portfolios have about 85% of their risk concentrated in market beta, with the remainder in term risk (if the portfolio uses Treasuries and CDs), and a small amount in credit risk (if the portfolio includes investment-grade corporate bonds).

To further diversify risk, and to improve the efficiency of the portfolio, investors need to add investments that have earned unique premiums (meaning they have low correlation with the portfolio’s other investments) and have demonstrated persistence, pervasiveness and implementability (meaning they survive transaction costs).

Decreasing Market Beta

The purpose of adding assets with these characteristics is to decrease the portfolio’s exposure to market beta to, in turn, reduce the dispersion of potential returns and, thus, tail risk without significantly reducing expected returns. The result would be a more efficient portfolio.

Consider the following example. You have the choice between Portfolio A and Portfolio B. They both have the same expected return, but the expected standard deviation of returns for Portfolio A is higher than for Portfolio B, resulting in fatter tails in the dispersion of potential outcomes.

Those fatter tails offer the opportunity for Portfolio A to experience both higher returns and larger losses than Portfolio B.

That’s the trade-off—to reduce risk and create a more efficient portfolio, you sacrifice the potential for higher returns in good years (when the market beta premium is larger than expected) to lower the risk of larger losses (when the market beta premium is negative).



Replacing Bond Allocation With Alts

If you are like most people, because you are risk averse, you would choose to live with the risks of Portfolio B—sacrificing the opportunity to earn the great returns in the right tail of Portfolio A’s distribution (that don’t appear with Portfolio B) if you also minimize or eliminate the risk of the very bad returns in the left tail of Portfolio A’s distribution (that, again, don’t appear with Portfolio B).

Investors can also consider using the alternatives I will discuss to replace safe bond investments. Doing so would create a portfolio with significantly higher forward-looking expected returns while its estimated volatility would rise only slightly, though term/inflation risk would be significantly reduced.

It is important to understand that expected returns are the mean of a very wide potential distribution of possible returns. Thus, they are not a guarantee of future results. Expected returns are forward-looking forecasts and are subject to numerous assumptions, risks and uncertainties, which change over time, and actual results may differ materially from those anticipated in an expected return forecast. Expected return forecasts are hypothetical in nature and should not be interpreted as a demonstration of actual performance results or be interpreted as a target return.

A Look At Alternative Funds

With that understanding, I will review the performance of four alternative funds in both 2017—a year in which the market beta premium was much higher than the historical average and what investors should have expected—and during the recent correction in 2018. Doing so will allow us to determine if the results were what we should have expected to see in each case. (Note that all of the following alternative funds are relatively new, and thus the sample we can review is limited.)

The following tables show the performance of the AQR Style Premia Alternative Fund (QSPRX) and three funds from Stone Ridge: the Alternative Lending Risk Premium Interval Fund (LENDX), the Reinsurance Risk Premium Interval Fund (SRRIX) and the All Asset Variance Risk Premium Interval Fund (AVRPX). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Stone Ridge and AQR funds in constructing client portfolios. I personally have significant investments in each of these four strategies.)


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