Swedroe: Alternative Approach To Alts

March 05, 2018

Traditionally, most portfolios have been dominated by public equities and bonds. The risks associated with the equity portion of those portfolios are typically dominated by exposure to market beta. And because equities are riskier than bonds, market beta’s share of the risk in a traditional 60/40 portfolio is actually much greater than 60%. In fact, it can be 85% or more.

The severe financial crisis of 2008 led many investors, including institutions, to search for alternatives. Among the usual suspects were private equity and hedge funds. Unfortunately, the evidence demonstrates that the correlation to equities of both these alternatives has been quite high.

For example, Niels Pedersen, Sebastien Page and Fei He—authors of the study “Asset Allocation: Risk Models for Alternative Investments,” which appeared in the May/June 2014 issue of the CFA Institute’s Financial Analysts Journal—found that the correlation of private equity and hedge funds to stocks was 0.71 and 0.79, respectively.

Most of the returns to those types of alternative investments are explained by the returns to stocks (in other words, the same market beta risk they are trying to diversify). This is the same conclusion that Cliff Asness, Robert Krail and John Liew reached in their 2001 study, “Do Hedge Funds Hedge?

Elusive Alpha

Making matters worse is that alpha has proved elusive. The historical evidence on the performance of private equity and hedge funds, as presented in my book, “The Only Guide to Alternative Investments You’ll Ever Need,” isn’t good.

What’s more, other traditional alternatives, such as real estate investment trusts and infrastructure, also have relatively high correlations with stocks. Among traditional alternatives, the only two that have shown almost no correlation to stocks were commodities and timberland.

For investors seeking other alternatives, in October 2013, AQR Capital Management introduced an interesting option—the AQR Style Premia Alternative Fund (QSPIX: expense ratio 1.6%). In November 2014, the firm introduced a lower-cost version (QSPRX: expense ratio 1.5%). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)

Traditional mutual funds are long-only, allowing investors to capture only a portion of a factor’s premium. On average, about half the premium from a factor comes from the short side and half from the long side. In addition, being long-only results in portfolios dominated by market beta.

Greater Factor Exposure

QSPRX, however, is a long/short fund able to capture both sides of the premium. It invests across four styles (or factors), each of which has support in the academic literature. Thus, the fund allows investors to achieve greater exposure to factors that have delivered premiums without having any net exposure to market beta (equity risk). Each of the four styles (value, momentum, carry and defensive) is backed both by economic theory and decades of data showing long-term performance across geographies and asset groups.

Further support for factor-based investing strategies is provided by Antti Ilmanen and my colleague, Jared Kizer, in their paper, “The Death of Diversification Has Been Greatly Exaggerated,” which appeared in the Spring 2012 edition of the Journal of Portfolio Management.

The paper, which won the prestigious Bernstein Fabozzi/Jacobs Levy Award, made the case that factor diversification has been much more effective at reducing portfolio volatility and market directionality than asset class diversification.


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