Why Alts?

2015-12-27 Janet PAINT (002)We get this question a lot, particularly as the events of the Great Recession fade away in our mental rearview mirror and the current equity bull market plods on.

Drop a dime in the jukebox and throw on “What Have You Done for Me Lately” by Janet Jackson as that is what many investors are asking about alternatives (“alts”) these days. In most cases, the answer is “not much, Janet (or Miss Jackson if you’re nasty).” But that shouldn’t cause us to change course and remove this extremely valuable asset class from your portfolio.

In fact, this is exactly the time when alts are essential to a diversified portfolio. Let’s reiterate why alts are such an important portfolio component: they are in there as a diversifying complement to the rest of your portfolio asset classes; the zig to their zag. This diversification comes in quite handy when equity returns decline, volatility increases, and interest rates rise. All of which are happening now.

So, you’re correct Miss Jackson, alts have not done much for us lately. But, as we pointed out at our fall seminars, what happens lately doesn’t dictate what will happen in the future. Recency bias is the erroneous significance that people put on recent events. As humans, we are innately emotional and hard-wired to think that these recent events will continue indefinitely. But that’s not how market cycles work. Many times, the best performer in one calendar year is one of the worst the following year. For example, REITs (Real Estate Investment Trusts) were one of the top performers in 2006 only to be at the bottom in 2007. Emerging markets were one of the best performers in 2007, only to be the worst performer in 2008. On the flip side, investment grade bonds were near the bottom of the class in 2010, only to be one of the better performers in 2011. International stocks were near the bottom in 2011 only to be one of the best performers in 2012. Hence, just because equities (and large caps in particular) have had several relative strong years in a row and alts have had muted results, doesn’t mean that will be the case for the next several years.

From 2009 through early this year, equities were providing the bigger returns and a well-diversified investor benefited accordingly. But things are changing. The Fed just raised rates, oil continues to slide, consumers aren’t spending as much, and investors could see 2015 as the first negative calendar year total portfolio return since 2008.

And speaking of 2008, let us not forget how gruesome that year would have been for many investors if not for the alternative asset class that kept returns in check. Alts like precious metals, currency strategies, and others were actually up in a time when equity benchmarks were down huge!

A basket of alternatives that DWM follows hasn’t exactly been “chart-toppers” the last few years. But that’s okay. We don’t expect for these to be double-digit return producers. As a whole, we are expecting the alternative asset class to return somewhere around 4-7% per annum for the next several years. But more importantly, our expectations for alts is that they won’t be down dollar for dollar when equities have a 10% or worse correction.

And that’s the real beauty. By using alternatives and avoiding a blow-up like many hard-core equity investors did in 2008, you don’t have a huge hole to dig yourself out of. The bigger the hole, the harder it takes just to get back to break-even, move forward, and secure those long-term financial goals of yours.

So, you’re right Miss Jackson. Alts haven’t done much for us lately. But, if you don’t fall prey to recency bias, you may understand that it is what they may do for us soon that can be so important.