Alternative Strategies Allocation

Last week my partner and I participated in the webinar about Alternative
Investment strategies and how to position them in your portfolio. We also
discussed the types of alternative strategies that are out there.

 

We also talked about what is commonly called the Endowment Model
and below is the performance of the Harvard Management Company, which manages
the endowment of Harvard University and I see that they have excellent returns.

 

Historical Investment Return

 

	Harvard Management Company	Policy Portfolio Benchmark	60/40 Stock/Bond Portfolio
1 year	21.4%	20.2%	19.5%
5 years	5.5%	4.3%	4.9%
10 years	9.4%	6.7%	4.3%
20 years	12.9%	9.8%	8.3%

Source: Harvard Management Company Endowment Report September 2011

 

So how and why do we need Alternative Investment strategies? Just
because Harvard is using these strategies might not be good enough for us, so
let’s explore further. The basic reason for using these strategies is to
improve the risk/reward profile of your portfolio, in a common language what it
means is that you reduce your portfolio risk a lot, while you reduce your
portfolio return a little.

 

The reason is good, and the motivation is pretty clear. The investment
environment is not great — slow recovery, uncertain political direction in
Washington, European Euro crisis, Middle East turmoil, all contribute to our
anxieties and fears. The markets are quite unpredictable, with high correlation
between assets and geographies and high volatility. What we want and need is
some safety, as we certainly don’t want the repeat of 2008, our primary
objective is not to lose our principle investment amount. As Mark Twain
famously said that he is interested in the “return OF his money, rather than
return ON his money”.

 

So how do we achieve this. In order to answer this question, let’s
look at where returns come from. In general it is well known that investment
decisions by managers in the terms of selection of stocks and timing does
little to improve performance and actually hurts performance over a long time. According
to an influential study by Brinson, Hood and Beebower, stock selection and
market timing do not matter nearly as much as how you mix the building blocks
of your investment portfolio. They concluded that asset allocation and not
stock selection, explained over 90% of investment return. Although the study
has been controversial, the authors are clear that “individual asset class
policies, with given weights and broad market representation for returns,
appear to dominate portfolio return variations and, by extension, the returns themselves.”

 

What it means is that market timing and stock picking actually
decreased portfolio return. In other words, the key to a winning investment
strategy is not so much to choose the right investment or to decide on the best
time to buy or sell but to choose the right asset mix and then to stick to it.

 

The classic portfolio allocation, which is 60/40 to stocks and
bonds needs to be improved upon. A typical improved asset allocation is to include
international stocks and bonds and emerging markets stocks and bonds. This does
bring out better diversification and it does get us closer to better risk/reward
profile of our portfolio, but it is not enough. The new asset allocation is to
divide portfolio into what I call Asset Categories – financial, physical, hard,
other equity and alternative assets.

 

Stocks and bonds are the financial assets. Physical Assets are commodities
and things that we consume, Hard Assets are real estate, art and things that
last a long time, other equity are private equity and venture capital funds, and
Alternative Assets are Absolute Return, Hedged and  Long/Short strategies.

 

The reason the alternative assets help us achieve a better
risk/reward profile is because Alternative Asset strategies provide uncorrelated
to major indices returns, while lowering volatility. The investment objective
of these funds are to earn cash like returns, with several hundred basis
points.

 

Instead of the old 60/40 split I would recommend allocating 50% to
financial assets (including domestic, international and emerging markets stocks
and bonds), 10% to physical assets, 10% to hard assets, 10% other equity and 20%
could be allocated to hedged strategies

 

If you look further at allocations that Harvard has in the
portfolio you will notice the faster growing asset category is Absolute Return,
while most of the asset categories decreased, the absolute return allocation
increased by 30%, from 12% to 16%.

 

The evolution of the Policy Portfolio

 

Â	1995	2005	2012
Domestic Equities	38%	15%	12%
Foreign Equities	15%	10%	12%
Emerging Markets	5%	5%	12%
Private Equities	12%	13%	12%
Total Equity	70%	43%	48%
Absolute Return	0%	12%	16%
Commodities	6%	13%	14%
Real Estate	7%	10%	9%
Total Real Assets	13%	23%	23%
Domestic Bonds	15%	11%	4%
Foreign Bonds	5%	5%	3%
High Yield	2%	5%	2%
Inflation-Indexed Bonds	0%	6%	4%
Total Fixed Income	22%	27%	13%
Cash	-5%	-5%	0%
TOTAL	100%	100%	100%

Source: Harvard Management Company Endowment Report September 2011

 

If you follow this type of portfolio allocation scenario, you will
diversify your portfolio, reduce risk and in these uncertain times you will
sleep better at night.