Mike Dieschbourg, managing director for the Alternatives/Managed Risk Group at Federated Investors, talks about why alternative investing strategies are gaining increasing traction with investors.
Q PricewaterhouseCoopers estimates global alternative investment assets could top $15 trillion by 2020, nearly 3 times their level eight years ago. What’s the driver?
Quite frankly, fear. The wealth destruction that came from the steep sell-offs that bookended the past decade really spooked equity investors.
There’s a reason the individual investor was quick to sell but slow to buy equities in the post-2008 crisis bull market. Having learned the hard way that volatility and bear markets can arise quickly, damaging portfolios and setting back investing goals, they were and remain scared to get back in—and stay in—the equity market.
They aren’t enthralled with bonds either. They understand an ultra-low rate environment such as what we have now doesn’t lend itself to a lot of upside opportunity, particularly now that the Federal Reserve has initiated a rate-hike cycle, however slow and minimal.
The result: many are searching for options beyond “yesterday’s asset allocation and style bucket” strategies and are ending up in alternative investments.
Q How do alternative investments differ from traditional stocks, bonds and diversified investments?
At their core, alternatives follow the lead of two investing giants, the late Benjamin Graham and his protégé, Warren Buffett. Both were and are all about loss avoidance.
Many alternative investments tend to be broadly diversified but go well beyond that by focusing more on risk management. They emphasize securities that historically have exhibited defensive characteristics and tend to use futures to take long and short positions in an attempt to reduce volatility and lessen downside risk in turbulent markets such as what is occurring now. A unifying theme is putting risk aversion on an equal if not elevated footing relative to maximizing potential returns.
Q Doesn’t a “loss avoidance” approach undermine returns?
To the contrary, limiting losses can do a portfolio wonders. Just do the math. To get back to breakeven on a 20% loss, an investor would have to earn 25%. Recovering from a 50% loss would require a gain of 100%. In other words, the bigger the loss, the higher the recovery threshold.
Many are searching for options beyond “yesterday’s asset allocation and style bucket” strategies and are ending up in alternative investments.
Taking this a little further, let’s say an investor’s desire is to for an annual return of 8%. If his or her portfolio loses 20%, it would have to gain 35% the following year to obtain that return. A 50% loss would require a gain of 117%.
This is the thinking behind managed-risk and other alternative strategies. If an investor can reduce if not eliminate losses, he or she may be able to generate terminal values in line with if not higher than a portfolio that potentially earns more in up markets but is more exposed to losses in down markets. The goal is to get lower lows, though the converse—lower highs—also often is the case but benefitting from the power of compounding.
A recent Ned Davis Research analysis of S&P 500 returns over 16 years through 2015 found that a buy-and-hold approach would have generated annualized returns of 3.99%; missing the best 40 days would have caused annualized returns to plunge to -7.88%; and missing the worst 40 days would have caused annualized returns to jump to 18.25%! Sort of says it all, doesn’t it?
For more information contact: mdieschbourg@federatedinv.com
Past performance is no guarantee of future results.
Alternative investing, including use of futures and short positions, may involve risks different from or possibly greater than the risks associated with investing directly in securities and other traditional investments.
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