Alternative Investments: History of Performance and Their Risk-Return Frontier
Investors are rushing into liquid alternative investments more than any other fund category. According to Morningstar, alternative funds have grown from approximately $62
billion in assets at the end of 2008 to $179 billion as of the end of 2013. This explosive
growth mirrors that of hedge funds a decade earlier.
Alternative Investments:
History of Performance and Their Risk-Return Frontier
By Paul Hoffmeister and Thomas F. Kirchner, CFA
1 | QUAKER FUNDS
Investors are rushing into liquid alternative investments more than any other fund
category. According to Morningstar, alternative funds have grown from approximately $62
billion in assets at the end of 2008 to $179 billion as of the end of 2013.
1
This explosive
growth mirrors that of hedge funds a decade earlier.
The rush is understandable. The 2008-2009 financial crisis starkly reminded investors of
the significant loss potential of equity investments, and the Federal Reserve’s expected
departure from its unprecedented policy easing is raising concerns about risks to fixed
income investments. As a result, investors are naturally looking to diversify their portfolios
away from the risks inherent in the two traditional asset classes.
Arguably, the risks and uncertainties associated with stocks and bonds are why
institutional investors, who are highly focused on attractive risk-adjusted returns, have
been making alternatives an essential component of their diversified portfolios for
decades.
When it comes to deciding how to add alternatives to a diversified portfolio mix, it’s
important to know what you’re getting. An important maxim to remember is: all
alternatives are not created equal. Saying that one is invested in alternatives is akin to
saying, for instance, that one is invested in mutual funds. Both statements are simply too
ambiguous for the thoughtful investor.
To provide a useful starting point in evaluating how to add alternatives to one’s portfolio,
we distinguish in the following between some of the most common alternative
investments, examine the performance of each since 1990, and then incorporate them into
a traditional 60/40 allocation.
Historical Performance of Po
P
ular
a
lternatives
Alternative investments can be defined as any asset classes other than stocks, bonds or
cash. This catch-all definition includes commodities, real estate, and even art, wine, coins
and stamps.
Another, more specific definition for an alternative is an unconventional strategy for
investing in stocks and bonds that creates return streams and risk profiles meaningfully
different from traditional equity and fixed income investments.
2
The differing return
streams and risk profiles are why some hedge fund investors have been using these
strategies for decades. Some of the popular alternative strategies include merger
arbitrage, convertible arbitrage, market neutral, equity long/short, event-driven,
distressed investing and managed futures. This popularity has led to these alternative
strategies becoming increasingly available to mutual fund investors.
The data illustrated in Figure 1
3
shows the risk (represented by standard deviation) and
return performance since 1990 of these popular alternative strategies:
Since 1990, the average annual return of these seven alternatives was 10.39% with a
standard deviation of 6.70%. Not only did this group of alternative strategies annually
outperform the S&P 500 by 94 basis points, it did so with approximately 55% less risk (as
measured by standard deviation). These attractive risk-adjusted returns are what some
sophisticated investors are seeking.
One way to assess risk-adjusted returns is through the Sharpe Ratio, which measures the
performance of a portfolio by adjusting for its risk. Essentially, the Sharpe Ratio indicates
how much reward an investor receives for each unit of risk. Therefore, the higher the
Sharpe Ratio, the better the portfolio’s risk-adjusted performance has been.
Arguably, the risks and uncertainties
associated with stocks and bonds are
why institutional investors, who are
highly focused on attractive risk-adjusted
returns, have been making
alternatives
an essential component
of their
diversified portfolios for decades.
© 2014 Quaker investment
t
rust
HFRI ED: Merger Arbitrage Index
HFRI RV: Fixed Income - Convertible Arbitrage Index
HFRI EH: Equity Market Neutral Index
HFRI Equity Hedge (Total) Index
HFRI Event-Driven (Total) Index
HFRI ED: Distressed/Restructuring Index
HFN CTA/Managed Futures Index
Barclays U.S. Aggregate Bond Index
S&P 500
MERGER ARB
CONVERTIBLE ARB
MARKET NEUTRAL
LONG/SHORT
EVENT-DRIVEN
DISTRESSED
MANAGED FUTURES
FIXED INCOME
EQUITIES
RETURN
STANDARD DEVIATION
16
14
12
10
8
6
4
2
0
FIGURE 1:
RISK-RETURN GRAPH (01/1990 - 12/2013)
FIGURE 2
4
:
SHARPE RATIO COMPARISON (01/1990 - 12/2013)
MERGER ARB
CONVERTIBLE ARB
MARKET NEUTRAL
LONG/SHORT
EVENT-DRIVEN
DISTRESSED
MANAGED FUTURES
FIXED INCOME
EQUITIES
SHARPE RATIO
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
Asset classes represented by the same indexes shown in Figure 1.
Al
TERNATI
v
E
IN
v
ESTMENT
S
: H
ISTOR
y
OF
P
ERFORMANCE
AND
T
HEIR
R
ISK
-R
ETURN
F
RONTIER
| 2
Not surprisingly, the average Sharpe Ratio of 1.09 for these seven alternatives is
meaningfully higher than the 0.41 for the S&P 500. It is also higher than the 0.87 Sharpe
Ratio for the Barclays Aggregate Bond Index.
tH
e “
a
lternative
r
isk-
r
eturn
f
rontier”
This scattergram (Figure 3
5
) of the returns and standard deviations of alternatives
illustrates how these popular investment strategies generate highly attractive returns
with attractive risk. We call this: the “Alternative Risk-Return Frontier”. And it is our belief
that investors are looking to alternatives to achieve investment performance that lies
specifically on this frontier.
i
ncor
P
orating a
lternatives into a
t
raditional 60/40 Portfolio
So how can an individual think about adding alternatives into their portfolio?
Nadia Papagiannis, formerly the director of alternative fund research at Morningstar Inc.,
has stated that an allocation to alternatives should begin with at least a 5% allocation,
although in order to have any kind of real impact, that allocation should grow to at least
20%.
6
Some university endowments are reported to have allocations as much as 40%.
7
The table shown in Figure 4 portrays a traditional retail portfolio built upon a 60/40
allocation. Between January 1990 and December 2013, this hypothetical portfolio of 60%
stocks and 40% bonds would have generated an annualized 8.74% return with a standard
deviation (representing volatility) of 9.07% (when rebalanced annually).
Based on the historical data, by adding a 20% allocation comprised of the seven previously
mentioned alternatives (equally weighted) and equally reducing the portion devoted
to stocks and bonds, the hypothetical investor increased his or her annualized return to
9.22% and reduced standard deviation to 8.12%.
There may even be a simpler, more convenient solution than a basic 20% allocation to the
seven alternatives: allocating to one alternative whose performance during the long-term
approximately resembles that of the aggregated seven.
While not exactly alike, the risk-return profile of a 50-30-20 portfolio using only event-
driven as the alternative investment since 1990 produced returns and created risks similar
to one utilizing all seven popular alternative strategies as their 20% allocation.
Specifically, the 50-30-20 allocation between stocks, bonds and alternatives where the
allotment to alternatives is only to event-driven, produced a 9.41% annual return with
8.50% standard deviation. This compares to an annual return of 9.22% and standard
deviation of 8.12% for the 20% allocation comprising each of the seven alternatives.
Why did event-driven produce returns and risks since 1990 as an allocation similar to
some of the most popular alternatives? The answer may lie in the fact that the event-
driven strategy has historically been a multi-strategy investment vehicle incorporating
other alternative strategies, such as merger arbitrage and distressed investing. As a result,
the multi-strategic nature of event-driven may be one important factor in enabling it to
perform within the heart of the coveted Alternative Risk-Return Frontier.
all rights reserved. m
ay not be reproduced or redistributed in whole or in part.
FIGURE 4
8
:
risk/return
taBle
January 1990 - december 2013: annualized s
ummary s
tatistics
Return
Standard Deviation
Barclays U.S. Aggregate
6.56%
3.72%
S&P 500
9.37%
14.88%
60/40 Equities/Bonds (“Traditional” Portfolio)
8.74%
9.07%
50/30/20 Equities/Bonds/7 Popular Alts*
9.22%
8.12%
50/30/20 Equities/Bonds/Event-Driven*
9.41%
8.50%
*
Rebalanced Annually
FIGURE 3:
RISK-RETURN SCATTERGRAM (01/1990 - 12/2013)
Less Risk
More Risk
0%
4%
8%
12%
16%
2%
6%
10%
14%
Standard Deviation
Higher Return
12%
10%
8%
6%
4%
2%
Lower Return
0%
14%
MARKET
NEUTRAL
FIXED INCOME
LONG/
SHORT
COVERTIBLE ARB
EVENT-DRIVEN
DISTRESSED
MERGER ARB
MANAGED FUTURES
EQUITIES
THE ALTERNATIVE RISK-RETURN FRONTIER
Asset classes represented by the same indices shown in Figure 1.
FIGURE 5
9
:
RISK-RETURN SCATTERGRAM (BlENDED PORTFOlIOS 01/1990 - 12/2013)
Less Risk
More Risk
0%
4%
8%
12%
16%
2%
6%
10%
14%
Standard Deviation
Higher Return
12%
10%
8%
6%
4%
2%
Lower Return
0%
14%
TRADITIONAL PORTFOLIO
60% EQUITIES
40% FIXED INCOME
50% EQUITIES
30% FIXED INCOME
20% EVENT-DRIVEN
50% EQUITIES
30% FIXED INCOME
20% IN THE 7 POPULAR ALTS
Asset classes represented by the same indices shown in Figure 1.
Asset classes represented by the same indices shown in Figure 1.
e
ndnotes
1-2 How Alternative Are Alternative Funds by Adam Zoll, Morningstar, January 15, 2014.
3 Risk-Return Table (January 1990 - December 2013: Annualized Summary Statistics). Source: Zephyr StyleAD
vISOR®.
4 Sharpe Ratio Comparison (January 1990 - December 2013: Annualized Summary Statistics). Source: Zephyr StyleAD
vISOR®.
5 Risk-Return Scattergram (January 1990 - December 2013: Manager Risk/Return Single Computation). Source: Zephyr StyleAD
vISOR®.
6 InvestmentNews.com, “Allocate Enough in Alts to Make a Difference,” by Bruce Kelly and Jason Kephart, September 23, 2013.
7 National Association of College and University Business Officers.
8 Risk-Return Table (January 1990 - December 2013: Annualized Summary Statistics). Source: Zephyr StyleAD
vISOR®.
9 Risk-Return Scattergram Blended Portfolios (January 1990 - December 2013: Manager Risk/Return Single Computation). Source: Zephyr StyleAD
vISOR®.
Past performance does not guarantee future results.
Alternative Investments are speculative and involve substantial risks. Alternative investments may result in additional risk due to their complexity and possible illiquidity
and require specialized investment expertise. Investments in smaller companies involve additional risk such as limited liquidity and greater volatility than larger
companies. Investors may lose some or all of their investment.
Direct investment in an index is not possible and securities in a Fund will not match those in an index.
There is no assurance that a portfolio will achieve its investment objective. In addition, there is no guarantee that any investment strategy will work under all market conditions, and
each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Portfolios are subject to market risk, which is the possibility
that the market values of securities owned by the portfolio will decline. Accordingly, you can lose money investing in this strategy. Please be aware this strategy may be subject to certain
additional risks, which should be considered carefully along with the strategy’s investment objectives and fees before investing.
s
tandard deviation
is a portfolio risk statistic used to measure variability of total return around an average, over a specified period of time.
mutual fund investing involves risk, including the possible loss of principal.
Consider a fund’s investment objectives, risks, charges, and expenses carefully before investing. The Statutory, and where available, the Summary Prospectuses contain this and other important
information and are available for download at www.quakerfunds.com or by calling 800.220.8888. Read carefully before investing.
©2014 Quaker® Investment Trust |
The Quaker® Funds are distributed by Foreside Fund Services, ll
C.
QKANE 022014
Contact us:
Quaker® Funds, Inc. c/o U.S. Bancorp Fund Services,
ll
C | P.O. Box 701, Milwaukee, WI 53201-0701
800.220.8888 | www.quakerfunds.com
Next
More from Thomas Kirchner
Thomas Kirchner, Camelot Event-Driven Advisors
Crypto fails to live up to its promises of peer-to-peer disintermediation. Abysmal safety and soundness. Reboot and return to its roots are needed. The FTX debacle puts a hard stop to the dream of alternative digital currencies. A peer-to-peer cash ...
Nov 23, 2022
Thomas Kirchner, Camelot Event-Driven Advisors
From substitute for war to forcing domestic policy change. Declining success rate of sanctions in the last 25 years. Russia sanctions cost West more than Russia. World needs a new Vienna Congress. In 433 BC, Athens barred merchants from neighboring ...
Apr 07, 2022
Thomas Kirchner, Camelot Event-Driven Advisors
by Thomas Kirchner, CFA & Paul Hoffmeister Since the beginning of the crisis, perma bears and perma bulls have disagreed about whether we are headed for a severe depression or whether there will be a rapid V-shaped recovery once the economy opens up ...
May 13, 2020
Thomas Kirchner, Camelot Event-Driven Advisors
An Arbitrageur’s View of Negative Oil Prices
Apr 24, 2020
The most important insight of the day
Get the Harvest Daily Digest newsletter.
