Myth Busting: Alts’ Uncorrelated Returns Diversify Portfolios
Being alternative is not good enough
December 2022. Reading Time: 10 Minutes. Author: Nicolas Rabener.
- Alternatives with lower correlations to equities & bonds did not lead to greater diversification benefits
- Correlations often break when markets crash
- Better metrics are required to measure the diversification potential of alternatives
Alternative investments accounted for $13 trillion in assets under management (AUM) in 2021, nearly twice what it was 2015. By 2026, that figure is expected to reach more than $23 trillion, according to Preqin research. Boom times are here for venture capitalists, private equity (PE), and hedge fund managers.
Although 2022 hasn’t been kind to venture capital, among other alternatives, some fund managers are faring better than others. Why? Because they can finesse their investments’ valuations. PE funds have no daily mark-to-market accounting, so they can smooth losses out across several quarters (read Private Equity: Fooling Some People All the Time?).
The ingenuity of this practice is that even though they have similar risk exposure, PE returns appear uncorrelated to equities. On paper, everything looks great.
Correlations are the hallmark of alternative investments. Generating uncorrelated returns in a year when the traditional 60/40 equity-bond portfolio has posted double-digit losses is a quick way to capture investor interest and capital. However, correlations are like icebergs floating in the sea, there is a lot hiding beneath the surface.
So just what are the pitfalls of using correlations to choose alternative strategies?
THE ALTERNATIVE CHAMPIONS
To find out, we selected seven well-known strategies from the hedge fund universe that have attracted billions from capital allocators. Our data is sourced from HFRX, which has daily returns going back to 2003. This nearly 20-year period covers several market cycles when alternative strategies should have demonstrated their value by providing diversification benefits.
We calculated these hedge fund strategies’ correlations to traditional asset classes. Three of these strategies —