A good alternative investment will deliver positive risk-adjusted returns over time at lower correlation to one's existing traditional portfolio. The goal of alternative investments is to improve the risk-adjusted return of the entire portfolio. Just as a traditional portfolio is diversified between stocks and bonds, and perhaps commodities, it can be prudent to diversify a portfolio of alternatives.
There are a few ways to build a portfolio of alternative investments. One method is to allocate to a multistrategy alternative fund, which can be found in Morningstar's Multialternative category. Another method is to equally allocate between a few alternative funds. Yet another and more complicated method is to use an optimizer, such as those found in Morningstar EnCorr
or Morningstar Direct
, to arrive at a set of optimal portfolios that maximize the expected returns at each level of risk.
There is no standard amount to allocate to alternative investments. Most advisors, per the Morningstar Barron's annual alternatives survey, allocate 10% or less to alternatives, while many institutions allocate 25% or more. Generally, as alternatives are risk-reducing investments, conservative investors should allocate more to alternatives than aggressive investors.
demonstrates a simple, three-fund alternative portfolio in which a long-short equity fund, a market neutral fund, and a managed futures index (as most managed futures funds have limited track records) are equally weighted among one another, but in different proportions to the entire portfolio. The long-short equity fund provides the potential for upside return, much like the equity portion of a traditional portfolio. The market neutral fund provides low-risk downside protection, much like the bond allocation in typical portfolios. The managed futures index represents uncorrelated returns, much like a standard commodity allocation.
When incorporating 5%, 10%, and 25% hypothetical allocations (out of equity) to the equally weighted, three-fund alternative portfolio, the historical risk-adjusted returns of a standard 60/40 stock/bond traditional portfolio are improved in each case. In fact, a larger allocation to alternatives creates a superior risk-adjusted return than the smaller allocations in this exercise.
Another way to arrive at an alternatives allocation is to use an optimizer. Optimizers require expected return, standard deviation, and correlation inputs to produce an efficient frontier of optimal allocations at each level of desired risk. We ran an optimizer example in which the inputs were: Morningstar Ibbotson's expected return and standard deviation forecasts for traditional asset classes; historical correlations; and historical expected returns and standard deviations for the same three alternative investments in the previous example. Each investment is capped at 25%.
The area graph in
demonstrates that at low levels of desired risk, it is optimal to allocate more heavily to managed-futures, market-neutral, and long-short equity strategies than at higher levels of risk. An allocation to all three alternative investments appears at each level of the efficient frontier (see
), meaning these alternatives improve the overall risk-adjusted returns of the overall portfolio.