Is the time coming for traditional investments to step aside?
By 2015, they are expected to account for a full quarter of retail brokerage revenues, an increase of 92 percent over 2010, according to a 2012 McKinsey & Co. study.
As of the end of 2011, a record $6.5 trillion has been invested in them, and they currently capture seven times the cash in-flow of traditional asset classes, according to the study.
And while the barriers to entry for individual investors have lessened to the extent that the public's appetite for them continues to grow unsated, Yale and Harvard have long seen fit to allocate their respective endowments with these types of investments.
This kind of breathless demand is often reserved for the release of the next iPhone, not a resurgent, complex field of investments. Especially not for one so uninspiringly referred to as "alternative investments."
Alternative to what?
Traditional asset classes typically include stocks, bonds and cash. As many investors have seen, Harry Markowitz's modern portfolio theory, which encouraged combining traditionally noncorrelated asset classes in a portfolio for better returns with less risk, may have begun to lose some of its luster after the market meltdown in 2008.
Those pie charts you're being shown during your account reviews are supposed to mean something. When an adviser is explaining them to you with such conviction, you know there's got to be something to it, right?
The point of the pie chart, from a high-level view, is to show you the percentage of your portfolio invested in bonds relative to the percentage invested in stocks. The greater the equity position, the story goes, the greater the risk. As risk in a portfolio increases, so does the opportunity for growth, volatility and even loss.
Modern portfolio theory suggests the proper allocation of bonds to stocks, according to an investor's risk profile, could result in better overall returns with lower standard deviations (meaning less volatility).
Given the fact that this theory requires both asset classes to have minimal correlations with each other in the markets, if that correlation disappears (meaning that if stocks and bonds begin to move more closely in tandem with one another), then the theoretical benefit of the pie chart has been devoured … you know, like a real pie.
All together now
Among equities, correlations have been on the rise. Studies have shown that the correlation among the stocks represented in the Standard and Poor's 500 Index has risen from roughly 10 percent in 1994 to 66 percent at the end of 2011.
Blame it on exchange-traded funds, blame it on passive investing strategies, or blame it on Lindsay Lohan, but where the blame lies is hardly the matter here.
You say that all those stocks in the S&P 500 are large capitalization stocks — wouldn't we expect them to show relatively similar correlations?
Touché. But consider that the correlation between large and small capitalization stocks recently hit its 60-year high.
And you think that is because we are dealing entirely in domestic stocks here and that you need more proof? Well, between 1970 and 2000, the correlation of annual returns between the S&P 500 and the MSCI EAFE (an index of international stocks) was 48 percent; since then, that correlation has risen to 95 percent, according to information reported on Seeking Alpha, a stock market blog.
Moreover, the last four decades of historical returns for stocks and bonds show disturbingly unsteady variations of sometimes positive and sometimes negative correlations. Positive correlations mean that two asset classes move in sync with one another, and negative correlations simply mean that the asset classes travel opposite the other.
Since July 2007, stocks and bonds have seemed to move in relative lockstep with one another, with both stock indices and bond indices seeing impressive returns over 2012. And if both can go up together …
What's an investor to do?
The list of solutions to this correlation problem is long and varied, and oftentimes it includes alternative asset classes.
The term itself is flexible and can encompass geographically focused securities (e.g. emerging markets mutual funds), hedge funds, private equity and physical assets (natural resources, real estate, etc.), and they are often characterized by their novel investing strategies.
For reasons too complex to expound upon here, many alternative asset classes are able to offer the benefit of limited correlation with tradable markets, and so they are beginning to serve as diversifiers in accordance with Markowitz's model.
With so many varied risks, and given their often opaque mandates (especially in the case of some hedge funds), investors would do well to study an alternative strategy proposed to them with an eye to liquidity, market risk, taxable consequence and volatility.
As markets continue to converge with increasing correlations across investments and asset classes, you can expect to hear more about alternative investments. It may be advisable to listen up, as so many institutional investors already have been for many years.
Anthony M. Conte is managing partner at Conte Wealth Advisors LLC in Camp Hill.
Registered Representative Securities offered through Cambridge Investment Research Inc., a broker/dealer, member FINRA/SIPC. Investment Advisor Representative Cambridge Investment Research Advisors Inc., a registered investment advisor. Cambridge and Conte Wealth Advisors LLC are not affiliated. Indices mentioned are unmanaged and cannot be invested into directly. Past performance is not a guarantee of future results.