The problem with diversification is that once everyone begins to own an asset class, it loses much of its non-correlated power.
At one time, all an investor really had to do was cross the ocean — into developed market international stocks — to pick up the value benefits of diversification. However, as almost investors’ portfolios now includes exposure to international developed market stalwarts like consumer products firm Unilever (UL) or Japanese mega-bank Mitsubishi UFJ Financial (MTU), international firms’ share prices pretty much move in lock-step with the S&P 500.
Ownership of international stocks begets exposure to emerging markets. Emerging markets beget exposure to commodity futures and real estate investment trusts. All with the same effect — as they become more popular, correlations among asset classes are getting stronger and closer together.
For investors looking for “true” non-correlated assets, that means looking outside the box to really take advantage of diversification. Luckily, recent changes in legislation means more alternatives are coming to a portfolio near you.
A Fund Giant Stakes Its Claim
Following Blackstone’s (BX) and a few other fund managers’ leads, bond house Pacific Investment Management has decided to dive head-first into the retail investor alternative asset management business.
Liquid alternative funds, more commonly known as “alts”, use strategies not found in regular stock/bond index or actively managed mutual funds. These more exotic ways of producing a return can be as simple as shorting — or betting against — stocks to more complex such as using managed futures or merger/arbitrage.
The basic tenet of alternative funds is to create consistent risk-adjusted non-correlated returns. Keep in mind that beating the market isn’t the real objective, and such funds can beat or underperform the broad stock market in any given year. Essentially, alternative mutual funds give retail investors access to the world of hedge funds and private-equity funds minus the exclusivity and lock-up periods.
The positives of adding such funds to a portfolio can be great. Obviously, the non-correlated nature of something like a 130/30 fund can provide zig when the market zags. That can offer downside protection in a major market event. Many alts strategies still produced positive — although small — returns during the financial crisis.
That zig can mean the difference between retiring in style or eating Alpo in our golden years.