June 8, 2022
Liquid Alternatives
A Case Study on Portfolio Diversification
Many of you are familiar with the phrase popularized by Nobel Prize winning economist Milton Friedman, “there’s no such thing as a free lunch.” This rudimentary economic principle tends to hold true within the realm of economic theory; however, this idea was put to task by Harry Markowitz in 1952 when he published his research paper on what is known as Modern Portfolio Theory. This eventually secured his spot alongside Dr. Friedman as a Nobel Prize winning economist. What Dr. Markowitz’s empirical research demonstrated is that within the context of investment portfolio management there exists an exception to the no free lunch principle. As he put it, “diversification is the only free lunch,” where allocating to a variety of assets with differing return profiles can result in a significant increase in a portfolio’s expected risk-adjusted return.
Today, the idea that portfolio diversification is beneficial to long-term investment performance is taken for granted. What is still debated, however, is which assets or strategies provide the best diversification benefits and how to best obtain access to these sources of diversification. We hope that this article will provide readers with a better understanding of how Greenleaf Trust employs a variety of exposures within a portfolio to best capture the benefits of portfolio diversification.
What are Alternatives?
Investment management practitioners and finance academics alike have long advocated for the use of stocks, bonds, and cash as the fundamental building blocks for private client investment portfolios. While we use these traditional asset classes as the primary allocations for client portfolios, we also believe that portfolio risk-adjusted returns can often be enhanced by allocating a portion of a portfolio to non-traditional investments.
Non-traditional investments, otherwise known as alternative investments, are generally defined as being any investment that is not accessible via the public markets or that uses complex investment and trading strategies. Common examples include Private Equity, Hedge Funds, Private Real Estate, and Private Credit.
Amongst these strategies, there are a wide variety of substrategies with widely varying return targets and risk exposures. They range from strategies targeting returns in excess of equities to strategies targeting lower returns, but greater diversification benefits. Additionally, many alternative investment strategies are offered in private investment vehicles that have limited liquidity and transparency as well as greater tax complexity and higher investment management fees relative to mutual funds. However, there exists a subcategory of funds, commonly known as liquid alternatives, that provides investors access to alternative investments in more liquid formats, including mutual fund and ETF structures. As you might imagine, some private investment strategies lend themselves to being offered in a liquid format more easily than others – liquid alternatives that replicate certain hedge fund strategies are most common.
At Greenleaf Trust, we appreciate liquidity and transparency when selecting investment strategies. Through our research, we identified Managed Futures and Merger Arbitrage as two of the more compelling liquid alternative approaches given the present market environment, their expected role within client portfolios, and their availability in liquid and transparent fund structures. A brief overview of these investment approaches is provided below.
Managed Futures
Managed Futures strategies seek to generate returns that are uncorrelated to the broad stock or bond markets by implementing long or short positions in the global futures markets spanning equities, bonds, currencies, and commodities. In essence, the approach uses computer models to identify market price trends across the globe and enter into trades that will benefit from the fall or rise in asset prices, a strategy known as trend following.
The purpose of this allocation is to provide diversification with an emphasis on downside protection during equity market sell-offs. To illustrate what this looks like, consider our recent market experience: global commodity prices rapidly increased while global equity and bond prices rapidly decreased. For investors that limit portfolios to only holding publicly traded stocks and bonds, there were few places to hide. This is where Managed Futures take center stage. During the market disruption, Managed Futures funds had the ability to take long positions in energy futures while at the same time enter short positions in equity and bond futures, thus benefiting from the rise in commodity prices as well as the fall in stocks and bonds. This allocation has provided diversification and compelling returns in the first four months of 2022.
Merger Arbitrage
Merger Arbitrage is a strategy that seeks to generate a “riskless” profit by exploiting market inefficiencies that occur during mergers and acquisitions. Here is how it works: when a public company announces its intent to purchase another company, there is a price discrepancy between the current price of the stock of the company being acquired and the price offered by the acquiring company. This difference in price vanishes once the deal is closed and so there is, in theory, a riskless profit to be made by simultaneously purchasing the stock of the company being acquired and shorting the stock of the company making the acquisition.
The purpose of this allocation is to reduce portfolio volatility and generate consistent returns in excess of those provided by core fixed income. While this strategy is certainly not riskless in practice – failed deals and imperfect hedging are common – it historically has generated low-to-mid single-digit returns with relatively low volatility and little correlation to equity and bond markets.
Incorporating Alternative Assets into a Portfolio
In the preceding sections, we identified an opportunity to increase portfolio risk-adjusted returns through diversification into liquid alternatives and recognized Managed Futures and Merger Arbitrage as two investment approaches that appear up to the task. After identifying the strategies, our next task is to determine the appropriate size of the allocation. We do this through a risk-aware process of modelling historical and expected future risk and return.
In 2021, Greenleaf Trust’s year-end capital market assumptions projected core fixed income returns below 2% over the next decade, with the majority of this return coming in the second half of the period. Based on our observations and expectations, we believed there was an opportunity to improve some portfolios’ risk-adjusted returns by tactically increasing the alternatives allocation, directing assets away from fixed income and into liquid alternatives.
Our objectives when increasing this allocation were to (1) improve expected risk-adjusted returns for portfolios, (2) maintain a reasonable level of overall portfolio volatility, and (3) control downside risk in stressed equity markets. Our preferred combination of alternative asset strategies facilitated these objectives because of their low correlation to traditional stock and bond markets. As illustrated in following table, the Managed Futures strategy we enlist has maintained a negative correlation to both stocks and bonds over the trailing three-year period ending April 30, 2022. Our preferred Merger Arbitrage strategy has generated positive returns, but low levels of correlation to stock and bond markets, with limited volatility.
At this point you may be wondering how the liquid alternatives allocation has performed relative to stocks and bonds over the five-month period since the change was enacted. The below graph shows the monthly return from the liquid alternatives allocation as well as the return from the S&P 1500 index and the Bloomberg US Aggregate index. These indices are commonly used as proxies for the US equity and fixed income markets respectively. As shown, the allocation generated positive returns in each of the five months, handily outperforming both stocks and bonds. While we know there will be periods when the alternative asset allocation will underperform in the future, the recent results are encouraging and validating of our investment research process.
It goes without saying that helping our clients achieve their financial goals is a top priority at Greenleaf Trust. Constantly working to ensure that the best available tools and methods are being employed in client portfolios is just one of the ways in which we work to meet this overarching goal. While future portfolio repositionings may not reap the same rewards as the one we discussed here today, we believe that proper portfolio diversification, the closest thing there is to a free lunch, along with steady stewardship and a long-term investment perspective, give our clients the best probability of achieving their financial goals.