People love the idea of alternative investments. I mean, they’re alternative, right? Why stick with plain old stocks and bonds when you can invest in cool-sounding investments like hedge funds and private equity.
But just how alternative are these other investment vehicles? After all, the whole point of adding alternative investments to a portfolio is to increase our level of diversification and, perhaps, enhance returns.
Well, it turns out that the most popular alternative investments just aren’t that different than the stock market. In fact, it turns out that “Factor Diversification,” a strategy of investing in different risk premiums, such as small, value and momentum, that help explain the returns of different types of stocks is a far superior way to diversify your portfolio and enhance its returns. (See here, here and here for a discussion of Factor Diversification.)
In their paper, The Tortoise and the Hare: Risk Premium versus Alternative Asset Portfolios, Ron Bird, Harry Liem and Susan Thorp found that hedge funds and private equity funds moved nearly in lock-step with the stock market. (For statistic geeks, the correlation of hedge funds and private equity to stocks from 1990-2009 was 0.79 and 0.71, respectively.) The authors concluded that most of the returns of hedge funds and private equity could be explained by moves in the stock market.
In other words, hedge funds and private equity are simply really expensive vehicles for investing in the same stock market that you could buy for 0.1% a year in a low-cost ETF or mutual fund.
Other popular alternative investments also showed only moderate diversification benefits. REITs and Infrastructure had a correlation of 0.59 and 0.58, respectively, to stocks. High-yield bonds had a correlation of 0.68 to stocks, showing yet again why high-yield bonds should be avoided. Bonds are for safety, so why invest in a class of bonds that gets hammered just when stocks are falling.
So it turns out that alternative investments aren’t all that alternative. Now, let’s see what Factor Diversification does for us.
The various risk premiums had very low to negative correlations to the stock market, which means that they’re often doing well when stocks are doing poorly – the very definition of diversification. The value and momentum premium had correlations to the stock market of -0.32 and -0.04, respectively, while the small premium was 0.27 correlated to the stock market.
The study’s authors found only two alternative investments that provided a diversification benefit on par with the risk premiums: Timberland and commodities both show basically zero correlation with stocks. However, each of those investments has a problem. Timberland, like farmland, must be purchased directly, meaning only large institutional investors can purchase it. Commodities can be bought by retail investors, but research has shown that the expected return of commodities beyond inflation is zero, so while commodities diversify your portfolio, you don’t earn any money for owning them.
The bottom line is that while alternative investments sound exciting and cutting-edge, they add very little a portfolio’s diversification and possibly a lot to its costs. Instead, you can add diversification and returns to a portfolio by including risk premiums such as small, value and momentum (as well as the more recently discovered Quality/Profitability premium).