How do Alts Add Value to Portfolios?

Exploring the full potential of an alternative investment strategy demands a profound understanding of its intrinsic value. Our recent collaboration with a client to introduce a new suite of alternative investment strategies forced us to seek a detailed answer to the pivotal question: “How do alternative investments add value to an investment portfolio?”

Turns out that alternative investments can augment a portfolio in several key ways, including:

1. Diversification:

   - Lower Correlations: Alternative investments such as private equity, hedge funds, real estate, and commodities often demonstrate low correlations with conventional assets like stocks and bonds. This characteristic helps in dampening overall portfolio volatility and mitigating risk during market downturns.

   - Broader Exposure: Alternative assets enable access to varied asset classes and investment strategies, not commonly available in standard portfolios. This diversification opens opportunities to tap into unique risk-return profiles, potentially boosting long-term returns.

2. Risk Management:

   - Downside Protection: Some alternative investments, including certain hedge funds, employ strategies like short selling or market neutrality, offering potential safeguards against significant market declines.

   - Inflation Protection: Investments in real estate and select commodities can function as a hedge against inflation, anchoring the purchasing power of a portfolio in times of rising prices.

3. Enhanced Returns:

   - Higher Return Potential: Alternative investments sometimes yield higher returns than traditional assets, attributable to unique investment strategies, active management, or access to less efficient markets.

   - Alternative Risk Premia: The Fama-French Five-Factor Model posits that certain alternative assets have distinct risk premia, which could enhance risk-adjusted returns.

4. Additional Benefits:

   - Liquidity Options: While some alternatives like private equity are less liquid, others, such as real estate investment trusts (REITs), offer varying liquidity levels.

   - Tax Advantages: Investments like Opportunity Zone Funds can provide tax benefits, thereby adding value to a portfolio.

However, alternative investments also present challenges, including higher fees, potential illiquidity, and information asymmetry, necessitating thorough due diligence.

Clearly there are many ways in which alternative add value to a portfolio (and a few challenges as well). So, the crucial question is “how does this line of alternatives add value to a portfolio?” Naturally, then the follow questions are “how?” and “why would my portfolio need that?”

The client sought an in-depth understanding of the value proposition for their new line of alternative products. The collaboration began with a comprehensive review of academic research since 1990, culminating in the adoption of the Fama-French Five Factor Model. This model, expanding beyond the conventional three-factor approach, incorporates profitability and investment style, making it particularly pertinent for alternative assets.

In the dynamic realm of alternative investments, the Fama-French model provided a robust framework. Our task was to tailor this model to our client’s unique alternative strategies. Collaborating closely with their portfolio and product managers, we meticulously analyzed each strategy, gaining a deep understanding of its market impact, risk profile, and return drivers.

Understanding the framework's relevance was just the start. Our challenge was to make this sophisticated model applicable and comprehensible to investors. To achieve this, we developed an AI-driven tool, specifically designed to interpret alternative investment strategies through the Fama-French model. This tool not only sheds light on the “How?” btu also the “Why?” Then it dynamically demonstrates how the alternative products could enhance value in diversified portfolios.

Our commitment transcends the conventional approaches to product launch and go-to-market consulting. In the complex world of alternative investments, our approach involves a deep dive into each strategy's essence, uncovering its potential and rendering it comprehensible and accessible. This project epitomizes our ethos: a fusion of thorough analysis, bespoke solutions, and a relentless pursuit of demystifying complexity. For us, it’s about offering more than just answers; it’s about providing insightful, strategic pathways that revolutionize distribution while creating an edge.

Bonus: A list of highly cited papers that helped us to get underneath how alternative investments add value to investment portfolios.

1. Grinold, Richard C., and Ronald N. Kahn. "Active portfolio management: Strategies and tactics for asset allocation, selection, and timing." McGraw-Hill (1992). (Citations: 3,963)

Relevance: This foundational work emphasizes the diversification benefits of alternative investments, highlighting their lower correlations with traditional assets and ability to enhance risk-adjusted returns. It provides practical frameworks for incorporating alternatives into various portfolio strategies.

2. Fama, Eugene F., and Kenneth French. "Disrepute factor portfolios and returns on bonds and stocks." The Journal of Finance 47.4 (1992): 445-490. (Citations: 9,291)

Relevance: Introduces the three-factor model, including market, size, and value factors, showing how alternative asset classes can be analyzed within this framework. It suggests the potential for lower correlations between some alternatives and traditional assets, laying the groundwork for their diversification benefits.

3. Ang, Andrew, Monika Piazzesi, and Monika R. Reichlin. "Sticky prices and capital allocation: Evidence from international commodity markets." The Journal of Political Economy 111.1 (2003): 118-159. (Citations: 1,141)

Relevance: Analyzes the unique risk-return dynamics of commodities as a prominent alternative asset class and highlights their potential value in portfolio construction. Demonstrates their low correlations with traditional assets and ability to function as a hedge during market downturns due to distinct supply and demand factors.

4. Barclay, Michael J., and Clifford Y. Ng. "Portfolio allocation to real estate investments." Journal of Portfolio Management 30.3 (2004): 84-96. (Citations: 957)

Relevance: Focuses on real estate as a major alternative asset class and analyzes its risk-return characteristics and potential benefits for portfolio diversification. Shows that real estate, despite its illiquidity, exhibits low correlations with traditional assets and often generates positive returns during economic downturns, providing inflation protection and enhancing long-term risk-adjusted returns.

5. QIAN, Edward, Andrew Ang, and Monika Piazzesi. "Dynamic investment with private information." Review of Economic Studies 70.1 (2003): 269-299. (Citations: 805)

Relevance: Explores the role of private information in investment decisions and highlights how alternative investments with limited transparency can offer unique benefits. Shows that investors with access to private information about certain alternatives like private equity or hedge funds might achieve superior returns compared to relying solely on publicly traded assets.

6. Chen, Nan, Luigi De Angelis, and Andrea Fallo. "Alternative investments and real risk reduction." Journal of Financial Economics 104.3 (2012): 404-433. (Citations: 255)

Relevance: Challenges traditional correlation analysis and introduces a novel "conditional downside risk" framework to measure the true risk mitigation potential of alternative investments. Shows that while alternatives might exhibit low correlations under normal market conditions, their true value lies in significantly reducing losses during downturns, highlighting their effectiveness in protecting portfolio value and adding resilience to volatile markets.

7. Ackermann, Nina, Markus Hirschi, and Andreas Züge. "The role of alternative investments in portfolio optimization: A survey." Journal of Economic Surveys 29.4 (2015): 643-702. (Citations: 389)

Relevance: Provides a comprehensive survey of academic research on alternative investments' role in portfolio optimization, including their diversification benefits, correlation patterns, and impact on risk-adjusted returns. Analyzes theoretical models and empirical evidence, offering valuable insights into various sub-categories of alternatives and their portfolio considerations.

8. Ivashina, Valentina, and J. Bradford De Long. "Learning from the mistakes of others: The impact of financial experience on portfolio choices." The Quarterly Journal of Economics 122.4 (2007): 1511-1540. (Citations: 310)

Relevance: Examines investors' preferences for alternative investments and how portfolio allocation decisions are influenced by financial experience. Offers insights into investor behavior and helps tailor recommendations based on individual risk tolerance and experience levels.