As you know, we’re quite focused on risk management in portfolios right now, and alternative assets serve a particularly important role in that regard because of their relatively low historical correlations with “traditional assets” (stocks and bonds). So the first and perhaps most important point we should make about alternative assets is that these assets are not expected to add risk to portfolios, and in fact, the way we employ them is specifically designed to reduce your portfolio risk.
We hold two types of alternative assets: “absolute return strategy” funds of different varieties, and various types of inflation hedges (“real asset strategy” funds) including gold, commodities, managed futures, oil & gas interests, and pipeline infrastructure investments. The purpose of absolute return investments is primarily to mitigate stock market risk, and the purpose of inflation hedges is to protect portfolios from the effects of inflation. Neither of these tools is perfect, and neither is held in portfolios in sufficient quantities to eliminate those respective risks. But these positions are designed to mitigate those risks and we continue to be convinced they will serve well in those roles.
However, as traditional assets have fared quite well since the stock market bottomed in the spring of 2009, alternate assets have not kept pace, and some clients have begun to question the wisdom of maintaining these holdings. Moreover, confusion about what we report as a performance comparator/benchmark for these assets has added to those questions.
During the credit crisis, stocks peaked late in 2007 and bottomed in early March of 2009. From 11/30/07 through 2/28/09, the annualized total return of the S&P 500 Index was -41.6%, and a rebalanced 50/50 mix of the S&P 500 Index and the taxable bond index produced an total return of -21.4% (REITs, small stocks, and international stocks were each worse than the S&P 500 over that period, so the 50/50 mix as a measure of traditional asset returns in this case understated true risk for this period). Over the same period, the alternative assets we held for clients on aggregate produced a total return of -13.5% (down but less than 63% of the decline suffered by traditional assets as measured by the 50/50 mix).
More recently, and on a much smaller scale, stocks slumped in the summer of last year, and alternative assets proved quite helpful. In the third quarter of 2011, the 50/50 mix of S&P 500 and taxable bonds returned -5.24% while the alternative assets we manage returned in aggregate +2.14%. (We made some adjustments after the 2008-09 experience to make these holdings materially more defensive, and the benefit of that was borne out in 2011.)
But with the exception of last summer, since the spring of 2009, traditional asset prices have generally soared and alternate assets have not: The total return of the 50/50 mix of stocks and bonds has been 15.1% per year from 2/28/09 through 6/30/12, while the total return of the aggregate of the alternative assets we manage was 5.2% per year.
One could make a simplistic analysis of that information that might go like this: “Alternative asset declines were only about 2/3 the size of traditional asset declines in the last bear market, yet have experienced only about 1/3 of the return of traditional assets during the subsequent recovery. They have provided benefits to portfolios at times, but in general, that seems like a bad tradeoff.” The problem with that conclusion, in our view, is that it ignores a critically important fact: inflation happened to have been very tame in each of these two recent periods considered.
We believe inflation remains a considerable risk to portfolios in the years ahead and we think holding some inflation hedges – assets whose prices tend to benefit from inflation rather than be harmed – is a critical component of risk management at this time. Since the timing of any future inflation is highly uncertain, we believe the best practice is to hold small amounts of inflation protection assets in portfolios at this time and to increase that exposure over time. Recognizing that the returns of inflation hedges are unlikely to be better than those of traditional assets during periods of tame inflation, we view that expected return give up versus traditional assets as akin to the payment of an inflation insurance premium: we are delighted we have fire insurance coverage for our house if it experiences fire damage, but the absence of a fire event does not make us inclined to drop the insurance coverage.
Beyond understanding alternative assets and their role in portfolios is the matter of reporting their performance, specifically the matter of the market benchmark to use. Unlike traditional assets and even real estate, there is as of yet no readily available and widely recognized index of the alternatives asset “market” that we can report and to which you may compare the performance of your alternative asset holdings. We are left with reporting a “benchmark” in this case that is not actually representative of this market. We currently compare the performance of alternative assets to that of a 50/50 mix of the S&P 500 Index and the taxable bond market (which is, of course, a proxy for traditional assets, not alternative assets). It does have the benefit of providing, if not a measure of the performance of the universe of alternative assets generally, at least a measure of the opportunity cost of holding alternative assets versus traditional assets. In the long run, that can be a useful measure. But in the short run, we recognize it can be more confusing than helpful and we continue to seek a better measure. In the meantime, please recognize that there is, by intent, very low correlation between the performance of the alternative assets we hold for you and the performance of traditional assets, so comparisons between the performance of your alternative assets and this 50/50 traditional asset “benchmark” does not carry information that is at all similar to the performance comparison we provide for any other asset class.
Separately, we are reviewing the way we report these holdings to determine if we continue to think it best to lump all alternative assets into one bucket or if it would improve understanding to break them out in to two components. Lastly, we continue to review and to seek to improve the specific holdings we have in the alternative assets area, as access continues to improve with more and more options available each year.
This year to date, alternative assets’ performance has been mildly negative in the face of very strong performance from traditional assets. Low correlation means that performance of alternative assets and traditional assets will not as likely to be strong at the same time, and are not as likely be weak at the same time. That’s a desirable thing in the long run. But in the short run it can raise questions about the advisability of the asset class, which we have attempted to answer here.
We remain concerned about a wide array of risks and continue to value the risk mitigation characteristics of alternative assets and view them as occupying an important place in your portfolio.