Friday, September 19, 2014

Alternative investments as a fixed income substitute?



A Pioneer Investments "blue paper" called "It's all about your core" provides some good insights on why alternative investments may be an effective addition or substitute within a fixed income allocation. 

The traditional stock-bond mix exists because there is significant diversification benefit between these two major asset classes. Bonds generally will be inversely correlated to equities, so they provide a natural hedge to market risk. (We will note that this story does not always hold but it has been a key driver to current asset allocation decisions.) 

Investors will usually further diversify their portfolio within asset classes and not just hold Treasuries in their bond portfolio. In the case of bonds, investors will hold credit sensitive investments to gain diversification and yield against Treasuries. However, the gain in diversification within the bond asset class will actually diminish the amount of diversification across asset classes. Credit sensitive investments will actually increase in correlation with equities during a crisis. Simply put, the characteristics of bonds as a safe asset in times of a crisis apply to Treasuries but not to other types of bonds. This is an obvious but often overlooked issue with portfolio construction.

In the first graph, the correlations of credit sensitive bonds to the S&P 500 equity index all increase during a crisis. The correlation between equities and Treasuries turns negative or declines. The second graph shows the actual returns during these crises. The declines in credit product returns are substantial relative to Treasuries. In some cases, the decline in credit sensitive bonds is greater than the decline in the S&P 500. Credit is a problem in times of  a crisis.

So what can an investor do? The short answer may be to look at alternative investments as an alternative to credit sensitive investments in your fixed income asset allocation. Substitute low volatility alternatives for credit in the fixed income allocation. There may be an even stronger case for this substitution given the current low spreads in credit product. Now substituting alternative strategy risk for credit risk may lead to a different set o portfolio risks, but this paper does a nice job of providing another reason for reviewing alternative investments.  

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