Using Alternatives to Reduce Portfolio Volatility

If your portfolio has ever declined more than you thought it should, it may be because you are missing a key component of your asset allocation and are not adequately diversified. Most advisors mistake diversification to mean that you have investments in US large cap, US Mid cap, US small cap, international equities, emerging market equities, and a mixture of long term and short term bonds, including both investment grade and high yield bonds.  

Well, as you probably have realized on occasion, that wasn’t enough to prevent your portfolio from declining an inordinate amount relative to the market and you may be wondering if this were to happen too often, you may not be able to retire as planned.  

The biggest mistake of the diversification claim is not including a variety of alternative assets that minimal exposure to the actual movements of the market, be it the equity or fixed income market. These types of investments are typically called alternative investments and although generally available only to the super-rich in the form of hedge funds, can also be mimicked through the use of a variety of mutual funds and ETF’s.   

If you have the investable assets to invest in hedge funds, they can be a great addition to a portfolio, provided they fit the appropriate risk/return profile and are thoroughly analyzed before making an investment. There are also mutual funds with daily liquidity that use hedge-fund like strategies but without the high minimums required by hedge funds. As with any asset class or strategy, there are advantages and disadvantages to using hedge funds or alternative mutual funds in any portfolio. Used properly however, and they can provide some interesting risk-adjusted returns.  

There are an increasing number of mutual funds that use alternative strategies much like hedge funds do.  One advantage is that they are cheaper and more liquid than most hedge funds. A mutual fund typically charges 1-2% management fee with no performance fee and can be liquidated on a daily basis. While hedge funds often charge a 2% management fee and 20% performance fee and they can only be redeemed every quarter with a 90 day advance notice and usually require a $1M minimum.  

Let’s say you are like the rest of us and don’t have the account size to invest in hedge funds. There are a variety of mutual funds that use alternative strategies that have also held up well throughout an entire business cycle. I would suggest looking for mutual funds that focus on long/short equity, market neutral and merger arbitrage. 

There are many excellent online tools that allow you to search for Alternatives within Fund Category. If you don’t have access to any of these tools, by all means, drop us a line and we will send you a short list to further analyze for your specific needs. Contact Us  

Despite my enthusiasm for all of these funds and they’re very talented managers, I wouldn’t recommend investing in any of these mutual funds without knowing what you are doing. Though the probability of a blowup is low for all of the funds I mentioned, there are specific macro-economic environments in which these funds excel and others where they may lag the more traditional fund strategies. Investing in them at the wrong time may disappoint so although they may be a permanent part of a well diversified portfolio, their allocation can be tactically increased/decreased based on market conditions.

To read more about hedge fund strategies, you may want to refer to Investment Strategies of Hedge Funds by Filippo Stefanini.