February 4, 2022 – In my 13 years of professionally managing alternative investment strategies, I have met with thousands of investment advisors, institutions and individual investors.
What became very clear very quickly was…
Alternative investments can be confusing, complex and time-consuming!
It is no wonder that many allocators stick with just stocks and bonds.
The vast majority of allocators do not have the time, resources or inclination to spend the hundreds of hours annually necessary parsing through alternative asset classes, researching alternative strategies, conducting due diligence on investment managers, trading / allocating, monitoring and rebalancing.
Constructing and managing a thoughtful, institutional-caliber alternative investment portfolio is a great deal of work. The process requires a significant amount of expertise and experience.
Investment advisors want efficiency in their practice to focus on what is most important, including servicing current clients and growing their practice. Therefore, there was a market need to solve the problem presented by alternative investments.
Given the Accelerate team’s more than six decades of alternative investment management experience, we thought, “let’s solve this problem and construct an easy-to-use alternatives portfolio solution for investment advisors, institutional investors and individuals.”
The Yale Endowment
The Yale Endowment, a $42 billion institutional portfolio run for the benefit of Yale University, is one of the most influential investment portfolios on the planet.
Pioneered by the legendary David Swensen, the Yale Endowment utilized an innovative approach to investing. This novel approach included diversifying beyond just stocks and bonds to include alternative assets in its portfolio. The purpose of having alternative assets within the endowment portfolio was to increase risk-adjusted returns by diversifying into uncorrelated assets (i.e. returns streams that move differently than traditional stocks and bonds).
This endowment portfolio has produced a unique risk-reward profile going back decades, and given its long-term success, its asset allocation framework is heavily replicated by other investors.
The core tenet of the endowment model portfolio is that of diversification. Specifically, the endowment model allocates to a diversified portfolio of alternative investment strategies.
Here is how they allocate their portfolio:
Source: Yale Endowment 2020 report
For their top three allocations, the Yale endowment has 21.6% in hedge funds, 15.8% in private equity and 22.6% in venture capital.
The endowment has 72.5% allocated to alternative investments, with the remainder in the traditional assets being stocks, bonds and cash. Contrary to most investors, the endowment has just 2.3% of its portfolio in U.S. equities.
This framework presents a dichotomy to investors, who typically allocate 60% to domestic stocks and 40% to domestic bonds.
The problem with allocating to just two asset classes (stocks and bonds) is that it is incredibly risky. Including alternative investments in a portfolio diversifies a portfolio beyond just stocks and bonds, reducing portfolio risk and volatility.
Why Alternatives?
There are five reasons for investing in alternative investment strategies:
- Risk reduction – Diversifying amongst uncorrelated asset reduces total portfolio risk.
- Yield generation – Producing income in a low-interest-rate environment.
- Mitigate volatility – Fortifying investment portfolios against large swings in the market.
- Enhance performance – Providing access to alpha-generating and thoughtful portfolios beyond just stocks and bonds.
- Protect purchasing power – Sheltering investment portfolios from the risk of inflation.
Source: Forbes, “The Holy Grail of Investing”
According to Forbes, “Wiser diversification is adding uncorrelated and low-correlation assets. Adding one uncorrelated asset (two assets in the portfolio) can reduce risk by 29 percent. Utilizing six uncorrelated assets reduces risks by nearly 60 percent.”
Alternative investments may improve risk-adjusted return not only by lowering risk but also by enhancing returns. Why is this important?
According to studies, individual investors expect to earn 10.9% returns over the next five years. Analysts forecast that the traditional 60/40 portfolio will earn just 2.8% annualized. There is a large divergence between investor expectations and analyst forecasts for traditional portfolios, and investors may be disappointed.
This forecast for poor returns for stocks and bonds is likely why the average institutional investor allocates more than 50% of their portfolio to alternative strategies.
The default investor portfolio has been 60% stocks and 40% bonds, with zero allocation to alternative investments.
If diversification is the only free lunch in investing, then why not have a free lunch?
A 0% allocation to alternatives is likely too low, however, a 50%+ allocation is likely too high. So where is the right balance? We believe that 50% stocks, 30% bonds and a 20% allocation to a diversified sleeve of alternative investment strategies may be optimal.
But how to construct the diversified sleeve of alternative investment strategies?
OneChoice Alternative Portfolio ETF
Accelerate’s mission is to democratize alternative investments. Specifically, our goal is to make alternative investment strategies accessible, easy to use, liquid, transparent and low-cost.
We thought long and hard about optimally constructing a diversified alternative investment solution that investors could utilize to augment their traditional portfolios.
In constructing the alternative portfolio, we first targeted risk. The ideal volatility for the alternative portfolio is 8%, which classifies as low-medium risk, and is roughly half of historical equity volatility. We felt that 8% volatility represents a strategy that does not fluctuate significantly, such that investors can stick with it and not sell at the lows due to emotional error.
The second part of the alternative portfolio design was its correlation with the equity index. We targeted a correlation of under 50%, indicating its performance would be driven by different fundamental drivers than the equity market, a sign of true diversification.
Third, which is less in our control, is the return target. We felt that an ideal targetted return would be the 7-8% range that pension funds target.
Taking into account forecast risk, correlation and return, we constructed the allocation that would form the OneChoice Alternative Portfolio ETF (TSX: ONEC):
Source: Accelerate
ONEC consists of six alternative asset classes and ten alternative strategies, most of which are generally uncorrelated with traditional asset classes and with each other. In addition, we believe that all of these asset classes have an attractive risk-reward profile.
Including generally uncorrelated strategies in the portfolio means that if all of the strategies are doing great (or all poorly), we have done a subpar job constructing the solution. Ideally, all of the strategies would move independently, with some performing well and some performing not so well each year, with the goal of reaching the 8% volatility target and high single-digit annual returns over the long term, irrespective of traditional asset performance. The objective of the alternative portfolio is not to pick which strategy will do the best this year. It is a long-term asset allocation framework to optimize long-term risk-adjusted returns.
The ONEC portfolio is systematic in nature, meaning we do not make fundamental calls on overweighting or underweighting asset classes. All ten strategies are equally weighted and rebalanced quarterly, which eliminates the potential for any human emotional errors due to market fluctuations.
ONEC launched on January 27, 2021, and completed its first live year last month. Here are its first-year results:
Source: Accelerate
ONEC has a volatility target of 8%, a correlation target of less than 50% and a return target of 7-8%.
ONEC’s 8.5% volatility in its first year is slightly above target, but close enough not to cause concern. In addition, its 43.9% correlation with the equity index equates to a low correlation, in line with our goal and indicative of a diversifying asset. Lastly, its 1-year return of 8.5% is slightly ahead of target.
Although one year of results is insufficient to draw any definitive conclusions, we are encouraged by the early signs that ONEC’s portfolio construction is working as designed.
Nonetheless, we believe that the endowment model of investing, which focuses on diversification to improve risk-adjusted returns, has merit. ONEC provides investors with an endowment-style asset allocation that is accessible, easy-to-use, liquid, transparent and low-cost.
In an era of increasing stock-bond correlations, perhaps diversification should be top of mind for investors. It certainly is for us.
Happy investing,
-Julian
Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.
