Are you getting enough diversification from your alternatives allocation?

Alternative investments have been used by some investors to diversify their holdings, and these may potentially help reduce overall portfolio risk when the appropriate strategies are implemented properly. Over the past year, the Invesco Global Solutions team examined hundreds of financial advisor portfolios, and we discovered that a common source of hidden risk is unintended equity exposure within alternative allocations, which can have an adverse effect on portfolio performance during equity market downturns. Fortunately, there are solutions that can potentially mitigate this risk and help investors achieve desired results.

Why alternatives?

Alternatives are any investment that falls outside of the boundaries of traditional, long-only positions in stocks and bonds. They include asset classes such as multi-asset strategies, absolute return strategies, equity strategies that can take short positions, real estate, infrastructure, master limited partnerships and more.

The main objective of including alternatives within a portfolio is to provide a differentiated source of return outside of the traditional equity and fixed income markets, as well as reduce overall portfolio volatility.1 As we approach the later innings of the equity bull market cycle, many investors and advisors are asking where to obtain the returns they are looking for and how to improve portfolio downside risk.

Figure 1 illustrates that a diversified alternatives portfolio has had similar returns as equities over the past 20 years, while delivering less downside risk in adverse market conditions during this period.

Alternatives have slightly outperformed equities when stock markets are stressed

Source: Invesco, August 1998 – March 2018. Past performance is not a guarantee of future results. Investments cannot be made directly into an index. Alternatives portfolio is represented by a portfolio consisting of: 20% Inflation-hedging assets; 20% Principal preservation strategies; 20% Portfolio diversification strategies; 20% Equity diversification strategies; 20% Fixed income diversification strategies. Traditional 60/40 Portfolio is represented by 60% S&P 500 Index and 40% Bloomberg Barclays US Aggregate Bond Index. Equities are represented by the S&P 500 Index. Fixed Income is represented by the Barclays U.S. Aggregate Bond Index. 20% Inflation-hedging assets are represented by 15% FTSE NAREIT US Real Estate Index Series, All Equity REITs and 5% Bloomberg Commodity Index. The 15%/5% split reflects Invesco’s belief that investors tend to invest in strategies with which they are more familiar. 20% Principal preservation strategies are represented by the BarclayHedge Equity Market Neutral Index. 20% Portfolio diversification strategies are represented by 12% BarclayHedge Global Macro Index and 8% BarclayHedge Multi-Strategy Index. Multi-strategy is underweighted in this example due to its potential overlap with global macro. 20 % Equity diversification strategies are represented by the BarclayHedge Long/Short Index. 20 % Fixed income diversification strategies are represented by the 20 % BarclayHedge Fixed Income Arbitrage Index.