Beyond the 60/40: Alternatives and their place in investment portfolios

Even in today's dynamic financial landscape, the age-old concept of diversification continues to shine as a fundamental strategy. But unlike many believe, diversification goes beyond holding multiple shares, or even the simple 60/40 portfolio where a balance of shares and bonds is deployed. What true diversification means is constructing a portfolio of assets that achieve return objectives over the business cycle. In other words, a portfolio of assets that are not correlated with each other. One asset class that provides value in this endeavour are alternatives. Alternative investments offer a nuanced approach, providing a blend of non-traditional assets that can enhance portfolio stability and mitigate volatility.

However, like everything in this world, the allure of these assets also brings with it inherent complexities and liquidity constraints, necessitating a comprehensive understanding before integrating into portfolios. Below we aim to provide an understanding of what alternative investments are, their merits, the risks and how Bratton’s investment committee goes about selecting appropriate opportunities.

What are alternative investments?

Alternative investments (also known as alts) are financial assets that do not fall into the category of traditional asset classes such as shares and bonds. Alts include a broad range of investments including private equity, property, real assets and other non-traditional assets.

Alternatives are generally uncorrelated with traditional assets, meaning that the price movements of alternatives do not follow the same direction as those of traditional assets like shares and bonds. For example, one of the real assets that we invest in here at Bratton Wealth are water entitlements. The prices of entitlements are mainly a factor of water availability and thus the price of these entitlements is not affected by typical market forces such as interest rates or geo-political events. This means that while the traditional assets in investors' portfolios fall during events such as the pandemic, the alternative portion of investors' portfolios can provide much needed resilience.

Evidence for Alternatives in Portfolios

In fact, according to Modern Portfolio Theory (MPT), a diversified portfolio with exposures to different uncorrelated asset classes tends to have lower volatility and can generate more consistent returns over the long term. This lower fluctuation in a portfolio’s value can provide comfort to investors who may have otherwise reacted irrationally to frequent portfolio movements such as those occasionally experienced in listed markets. The lower volatility smoothens the returns of a portfolio, and the compounded rate of return becomes uninterrupted by significant prices movements.

“The best way to make money is to not lose it in the first place.” – Brad Symes

Empirical evidence underscores the pivotal role of asset allocation in shaping portfolio outcomes, with studies indicating that it accounts for over 90% of performance. In their seminal work, "Determinants of Portfolio Performance" (1986), Gary Brinson, Randolph Hood, and Gilbert Beebower examined data from 91 major US pension funds (1974-1983), demonstrating that effective diversification significantly enhances long-term returns. This complements Harry Markowitz whose foundational research on Modern Portfolio Theory (MPT) underscores the importance of spreading investments across different asset classes to optimize risk-adjusted returns.

The MPT approach gained widespread adoption, notably by prestigious university endowment funds like those of the US Ivy League, such as Yale. David Swensen, who oversaw Yale's endowment from 1985 to 2021, steered the fund towards diversification beyond traditional public markets into alternatives. This strategic shift contributed to Yale's remarkable success, with net returns averaging over 12% annually since the mid-1980s. The accompanying chart illustrates the gradual ascent of alternative assets within the Yale endowment portfolio, with Real Assets, Private Equity and Alternatives now representing over 70% of Yale’s portfolio.

Types of Alternative Investments

Investors must grasp the nuances of various alternative strategies and their risk-reward profiles. Here's a concise breakdown:

Private Equity and Venture Capital: Private equity invests in unlisted companies to spur growth and eventual profitable exits, while venture capital focuses on early-stage firms, often in tech and life sciences. Selection of skilled managers is crucial due to varying returns and intense competition.

Real Assets: Tangible assets like infrastructure, property, and agriculture provide stable income and potential appreciation.

Infrastructure: Investments in infrastructure assets like roads and data centers can yield steady returns, especially those offering predictable cash flows.

Natural Resources: Renewable energy and water entitlements offer diversification and economic benefits, with potential for substantial returns.

Hedge Funds: Actively managed pools of investments using unconventional strategies like leverage and derivatives. They can benefit from market upswings and downturns, offering potential diversification and reduced volatility. However, high fees warrant careful consideration.

Digital Assets: Digital assets like cryptocurrencies operate independently of broader economic trends and are influenced by different market forces. This independence can help diversify an investment portfolio, as movements in cryptocurrencies may not align with those of stocks or bonds. Additionally, the decentralized nature of many cryptocurrencies can insulate them from macroeconomic events such as currency debasement, further enhancing their diversification potential.

Art & Collectibles: Art & Collectibles can provide potential for diversification and independence from traditional market trends. The global art market, valued at approximately $50.1 billion in reported sales (Art Basel and UBS Global Art Market Report 2020), offers investors opportunities to invest in assets driven by factors such as historical significance, artistic merit, and scarcity, rather than fluctuations in stocks or bonds.

How to choose an alternative investment

When opting for alternative assets to diversify your portfolio, it's crucial to recognize that while such diversification doesn't guarantee improved results, it does heighten the likelihood of attaining your investment objectives. Nevertheless, the success of your alternative investment hinges on the proficiency of the underlying investment manager in spotting mispricings and seizing promising investment opportunities. At Bratton Wealth, our Investment Committee meticulously conducts in-depth research and due diligence to identify top-performing specialist managers. Various factors are taken into account when selecting these managers, including their:

1.        Investment process

2.        Risk management strategies

3.        Performance track record (after fees)

4.        Fee structures

5.        Capacity constraints

6.        Alignment of interests

These factors are integral to our due diligence process and guide our investment decisions. If you're interested in learning more about Bratton's investment approach, please don't hesitate to reach out to us. Please contact us if you would like to learn more about Bratton’s investment process.

Bratton’s approach to alternative investment

Bratton's investment strategy focuses on constructing highly diversified portfolios comprising investments with low correlation. This approach enables our clients to maintain substantial investments across market cycles, yielding robust risk-adjusted returns aligned with their objectives. Access to superior investment opportunities is pivotal for achieving such outcomes, often restricted to institutions with significant investable assets and established relationships with fund managers. At Bratton, we've cultivated partnerships with specialist alternative managers consistently outperforming peers and benchmarks. Leveraging our scale, we offer clients access to institutional-grade research and alternative investments typically beyond reach for most investors. Through Bratton, clients gain exposure to specialist alternative investments tailored to safeguard and enhance capital across generations.

Conclusion

Alternative investments offer investors the opportunity to reduce portfolio volatility and correlations with traditional asset classes, thus safeguarding invested capital and mitigating downside risk during market uncertainties. When employed effectively, alternatives bolster the overall risk-return profile of portfolios, enabling investors to navigate turbulent market conditions with greater resilience. Consequently, diversified portfolios with alternative exposures are better equipped to weather market corrections and minimize the risk of substantial drawdowns.

Managing key risks, as outlined above, is imperative for safeguarding long-term capital. While diversifying into alternative assets alone doesn't guarantee improved results, it underscores the importance of investors and their advisers possessing research capabilities and access to select alternative managers with proven track records over the long term. Understanding the unique benefits and risks associated with alternative investments is essential, emphasizing the need for investors to discern the disparities between alternative strategies.

Engaging specialist advisers, such as those at Bratton, can aid in determining the suitability of incorporating alternatives into existing portfolios, considering each investor's distinct objectives and risk profiles. We trust you found this information valuable. Please feel free to email us to discuss an appropriate strategy for integrating alternatives into your investment portfolio.