According to Morningstar, $38.7 billion flowed into alternative investment mutual funds and ETFs over the year ended April 30, 2014. That’s about a 36 percent increase over the prior year and more than twice as much as two years ago.
When evaluating alternative investments, it’s important to understand their correlation to other traditional asset classes, stocks and bonds, as well as their correlation to other alternatives. And we believe one of the primary reasons for adding alternatives to a portfolio is to achieve noncorrelation to traditional asset classes.
The goal of modern portfolio theory is to blend different asset classes into a portfolio that seeks to reduce overall risk and volatility, and maximize return.
Historically, the addition of noncorrelating assets in a portfolio has seemed to lower overall portfolio volatility and improved the risk/return profile. The table below shows the correlation matrix between several alternative indexes from Hedge Fund Research and general market indexes over the past five years.
The matrix highlights that correlations vary greatly among alternative strategies when measured against traditional market indexes and against each other. Alternative asset classes have generally been negatively correlated to bonds and not highly correlated to equities, thus providing diversification benefit when allocated to a portfolio.
Alternative Correlations: 5 Years Ending 12/31/2013
Source: Morningstar Direct
For a larger view, click on the image above.
We often get the question, How much of a diversified portfolio should be invested in alternatives?
There is no single answer, as it depends on each client’s return objectives and risk tolerance, but we generally advocate that between 5 to 20 percent of a client’s allocation be to alternatives.