Diversification – do we need alternative assets?

Jason Baran, Insight Analyst (Investments)

Do we need alternative assets?  

It is frequently said that due to the ever interconnectedness of markets and economies the level of diversification that can be obtained via traditional asset allocation methods is decreasing. Particularly in times of panic, when investors are forced to sell due to other losses in their portfolio market behaviour can result in “all asset correlations go to 1”.  

The case for ‘alternatives’ 

The search for diversification leads many investors down the route of alternative assets. The theory being that equities, fixed income, property and now commodities were all so convenient to access that they had lost their diversification properties. Instead more exotic ‘alternative’ assets were required, such as hedge funds, infrastructure, fine art, wines, student accommodation, classic cars or claims on future litigation pay-outs. 

Indeed, the most recent example would be that since the 2008 crisis and the introduction of Quantitative Easing (QE), all assets across the board have been equally pushed up to record levels. It is then puzzling that some of the exotic investments mentioned above have also been reaching record levels. Do we only care about diversification when the main markets are falling?  

New ways to think about diversification  

As we mentioned in an earlier Defaqto article, portfolio constructors are moving towards modelling portfolios by risk factors as opposed to asset classes alone. The reason for this being that an investment in an asset class can contain several factors, and it is these underlying factors that are the source of real risk in a portfolio. For example, if we consider an equity index investment we can split this into factors possibly relating (but not limited) to: interest rates, corporate credit + bankruptcy risk, liquidity and fx risk.  

With the alternative assets above, we can similarly break down their returns into risk factors. Long-term interest rates play a part in almost all asset valuations and this goes someway to explain why all asset prices have been pushed up via the workings of QE.  

Returns that can’t be attributed to these traditional factors are referred to as ‘alternative beta’. This is the amount of true diversification an investor may gain, and often it is smaller than would be implied by looking at asset diversification alone. We should be very careful as we could include undetected risks in a portfolio if what we mistake alternative beta for another factor, such as liquidity risk. Particularly for alternative assets, there is usually a large amount of illiquidity and a premium should be received for this.  

No more free lunches 

It used to be that diversification could be considered a “free lunch” within portfolio construction. Diversifying your assets was an almost zero cost measure to implement beyond some extra trading costs.  

We still need diversification in a portfolio, but now market behaviour requires us to be smarter. That is, we need to accurately measure the amount of diversification an asset exposure may give us, using the factor based approach mentioned above, and we need to consider its diversification against illiquidity, research and trading costs.