Overview

Institutional investors such as pension funds and endowments have generally achieved higher “Risk Adjusted” returns than individual investors. Risk adjusted returns is an important concept to understand. It simply means how much return you are getting for the level of risk you are taking. Everyone would like higher returns. However, if the higher return comes with higher risk then it may not be beneficial. The goal for most investors is to get higher returns with the same (or preferably less) risk than they were taking previously.

Most investors only use traditional investments – owning some combination of stocks, bonds and cash. It is very difficult to achieve significantly higher risk adjusted returns by simply using these asset classes with a buy, hold and rebalance approach. In today’s economy, integrating alternative asset classes into your portfolio has never been more important.

What are alternative asset classes?

Alternative investments include, but are not limited to: real estate, private equity, hedged equity, commodities, currencies, futures contracts, arbitrage, and absolute return. (See appendix to this article for definitions.)

In addition to using alternative asset classes, most institutions have systems that they follow for risk management, and deciding when, and at what price to buy and sell various investments.

At SureVest Capital we build and manage investment portfolios for individual clients that are based on the demonstrated success and methodologies of large institutional investors.

Why are alternative asset classes so important?

1. Provide growth during long term cyclical bear markets (when markets move sideways for many years):

   Many individual investors design their portfolio while looking in the rear view mirror. They feel that they can count on stocks to deliver double-digit returns because they are relying on statistics extrapolated from 80+ years of market data. However, what happens when you experience a decade of zero returns in the stock market such as we saw from 1999–2009? It is even worse if the sideways market lasts for 17 years such as it did from 1966–1982, or 25 years from 1929–1954, or 18 years such as it did from 1906–1924 in the Dow Jones Industrial Average (see chart, Appendix A).
   
   This scenario (a long term sideways market) is even more devastating if you need to take distributions from the portfolio, as most retirees, as well as endowments and pension funds, must. More and more retirees and mid to high net worth investors want consistent returns that they can count on to provide systematic income in retirement. Endowments also need systematic income to support the operations of their institutions.

2. To Reduce Volatility:

   30 years ago, all you needed were stocks and bonds to have a diversified portfolio. However, it is important to understand that diversification does not mean that you simply hold many different investments. The key to diversification is to have a portfolio of investments that will not all decline at the same time. Therefore, you need some investments that go up when stocks and bonds are going down. Most major asset classes have become highly correlated over the last 30 years, meaning they now tend to move in the same direction. Institutions are relying on alternatives asset classes to behave differently, in order to cushion downturns by going up (or even sideways) when the stock and bond markets have significant downturns.

Why focus on consistent results (reducing volatility)?

Even the best money managers are going to have good years and bad years. However, by minimizing the severity of bad years, investors end up with higher compounding, which means a lot more money. Consider the following two investors:

They each have an average return of 5%, but Investor A ends up with much more money after just 3 years. This is because a portfolio with lower volatility compounds at a higher rate. The difference in the ending portfolio balance is more pronounced if the account owners were taking distributions from the portfolio each year, or if you look at a longer period of time.

For Example: from 1950–2007 the S&P 500 had an average annual return of 9.19%. Over that time period an investment with the same average annual return but half the volatility would have produced 60% more wealth!

The institutional approach to investing is not designed to hit “home run” returns of 20–30% per year (although years like that can occur). Instead it focuses on consistent compounding of more moderate results.

Who has been achieving consistently high risk adjusted returns?

What else are Institutional Investors doing to Manage Risk?

How can you get Institutional Quality Asset Management?

Appendix A: Dow Jones Historical Trends

Appendix B: Alternative Asset Class Definitions

Absolute Return: Absolute Return is any investment strategy designed to generate positive returns over a 3 to 5 year period, irrespective of the direction of stock or bond markets. They typically achieve this by investing the portfolio's assets in cash or other low volatility investments and then taking hedged long and short positions in portfolios of securities that, when combined, are expected to have modest exposures to market returns. The resulting portfolio should have low correlation with financial market performance. Of course, whether such a portfolio actually delivers a positive absolute return depends on the skill of the portfolio manager in selecting profitable long and short positions.

Arbitrage: Attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. The ideal version is riskless arbitrage.

Commodities: Any unprocessed or partially processed good, which is typically used as a raw material to be processed and resold, such as petroleum, wheat, or copper. Its price is determined by supply and demand in the global market. There is no product differentiation among different producers.

Currencies: Buying or selling the currencies of different countries in order to profit on trends in the relative strength of one currency vs. another. Currencies can also be used to hedge other exposure (i.e. buying the U.S. dollar to hedge commodities which are priced in dollars).

Emerging Market Debt: This is simply government bonds issued by countries known as emerging economies, such as Brazil, India and China.

Hedged Equity: Ownership of stock in publicly traded companies, which is then insured against declines in the value of the stock using options contracts.

Managed Futures: The active trading of “Futures contracts” which are contracts to buy or sell an asset (stock index, commodity, currency, fixed income or other security) for delivery at a specified future date at a specified price. This is similar to stock options except that they are applied to assets other than stocks. Traders usually employ quantitative or technical analysis and systematic investment processes which are designed to profit on price trends. The traders can profit regardless of whether the price trend of the underlying asset is up or down.

Private Equity: Ownership (i.e. stock) in operating companies that are not publicly traded.

Real Estate: Both domestic and international commercial real estate (office, industrial, multi-family, specialty).