Last year was a frightening wake-up call for many investors. It probably wasn’t a huge shock that equities lost ground—stock market volatility is expected. What was surprising, though, is that many investors endured double-digit losses in their bond holdings as well. Investors who include bonds in their portfolios expect them to balance the volatility of stocks—and with good reason. Prior to 2022, bonds had largely delivered that stability for decades—but that was with the benefit of low inflation and declining interest rates. When inflation and interest rates shot up in 2022, bonds failed to provide protection for portfolios that were already reeling from steep market losses.
Good news: Bonds are far from the only option to diversify an equity portfolio. There is a wide range of “alternative investments,” and some offer attractive returns and impressively low correlation with both stocks and bonds.
Bottom Line Personal asked Philip Huber, CFP, CFA, author of The Allocator’s Edge, to explain some of the best alternatives to provide protection from market volatility…
The term “alternative investments” may conjure up fears of hidden risks, high fees, illiquidity, tax complications and outright scams—but those fears are not always justified these days. In the past decade, new investment vehicles have appeared that allow access to a range of alternative investments that can make sense for the average investor.
Still, most investors should consider these alternative investments for only a modest portion of their portfolio, and they should do so with the assistance of a trusted financial advisor. These can be complex and unfamiliar, and it would be unwise to wade in too deep or without input from an expert. In fact, some alternative investments are available only through financial advisors.
Among the alternative investment categories that can provide solid returns and significant diversification when used to supplement a traditional stock and bond portfolio…
Managed futures funds use derivatives—contracts that derive their value from the performance of underlying entities—to take either long or short positions on equities, bonds, currencies and/or commodities. The fund manager makes investment decisions based not on investment fundamentals such as the valuation of a stock, but on historical price trend patterns rooted in the aggregate behavioral biases of investors—this strategy is sometimes called trend following. Historically, the long-term performance of managed futures funds has been highly uncorrelated with both stocks and bonds, even though at times these funds’ flexible derivatives strategies involve buying stocks or bonds. In fact, managed futures funds tend to do best when stocks struggle the most, and they exhibit virtually no correlation with bonds during periods when bonds struggle. Example: The iMGP DBi Managed Futures Strategy ETF (DBMF)—an exchange-traded fund that can reasonably be considered a proxy for managed futures funds—was up more than 30% during the first three quarters of 2022, a nine-month period when the S&P 500 was down 25% and the Bloomberg US Aggregate Bond Index was down roughly 15%.
Caution: The active trading strategies used by managed futures funds can generate significant tax bills, so these are best held in tax-advantaged accounts.
Real asset investments involve ownership of cash-generating tangible assets. Real estate is the most familiar real asset sub-category—Real Estate Investment Trusts (REITs) and REIT mutual funds can be found in many investors’ portfolios. But real estate is not the only type of real asset, and real estate failed to help investors offset recent stock and bond market setbacks—the Dow Jones US Select REIT Index fell 31% during the first three quarters of 2022. Other real asset investment options worth considering: Farmland, timberland and infrastructure (infrastructure involves everything from gas-distribution resources to wireless towers to railways).
Farmland, timberland and infrastructure have a positive sensitivity to inflation—their value tends to increase when inflation is high—which contributes to a relatively low correlation with stocks and bonds. These real assets can provide significant returns, too—farmland has outperformed the S&P 500 in recent decades, based on the NCREIF Farmland Index, while timberland has fallen short of stocks but outperformed bonds. Infrastructure investments have historically delivered returns greater than those of global equities with less volatility, based on research by the Canadian investment-management company Brookfield. It helps that infrastructure investments often are monopolies with high barriers to entry and stable cash flow.
Investing in real assets other than real estate traditionally has been difficult for individual investors, in part because many real assets are very illiquid. But now it’s possible to invest through ETFs, mutual funds and “interval funds.” Interval funds, a type of closed-end mutual fund sold through financial advisors, are “semi-liquid”—investors might have an opportunity to sell in limited amounts once per quarter, for example. Examples: Interval fund—Versus Capital Real Assets Fund (VCRRX)…ETFs—iShares Global Infrastructure Fund (IGF), Global X US Infrastructure Development Fund (PAVE) and VanEck Vectors Real Asset Allocation Fund (RAAX)…and mutual funds—Lazard Global Listed Infrastructure Institutional Fund (GLIFX) and Cohen & Steers Real Assets Class I Fund (RAPIX).
Private debt investments typically take the form of “corporate direct lending”—loans made by nonbank lenders to companies that have between $10 million and $100 million in annual earnings. Banks have backed away from lending to these middle-market borrowers in recent decades, opening the door for private investors to fill the void. If you’re familiar with private equity, think of this as the debt equivalent. This debt is not publicly traded, and it is typically below investment grade, but investors are well-compensated for its risks. Private debt typically pays higher yields relative to credit quality than publicly traded bonds. Private debt usually is floating rate, which means that investors can be protected from interest rate and inflation risk, and that helps make these an effective tool to diversify the bond portion of a portfolio. Example: The Cliffwater Direct Lending Index, the dominant index for this asset class, rose 4.2% while the bond market was struggling through the first three quarters of 2022. That index has delivered impressive 9.5% annual returns since its 2004 inception.
The best way for individual investors to access private debt is through interval funds or private business development companies (BDCs), a type of closed-end fund. Examples: Cliffwater Corporate Lending Fund (CCLFX)…Stone Ridge Alternative Lending Risk Premium Fund (LENDX)…Variant Alternative Income Fund (NICHX)…PIMCO Flexible Credit Income Fund (PFLEX)…BlackRock Credit Strategies Fund-Institutional (CREDX)…Blackstone Private Credit Fund (BCRED)…and Blue Owl Credit Income Corp (OCIC) formerly Owl Rock Core Income Corp (ORCIC).