There is this great delusion we have seen over many years at this that the word "Alternative" somehow means making money all the time, lots of it, with no risk. While this might be expected among the less experienced, many professional institutional types also seem to think this great nirvana state exists in the world of liquid, developed markets.
For context, its seems that the Alts world tends to revolve around a simplistic idea: correlation. Meaning, if you mix two assets and they are not correlated to each other, you get a portfolio return stream that might be less volatile and carry greater sustenance over time. That's the theory at least, inclusive of the idea of long and shorts too.
Now for reality, measured historical correlations are thrown around with limited underlying substance. In liquid markets, high, low or negative correlations are notoriously prone to breakdown over time and, most especially, in the short-term. Meaning, generally of limited value for portfolio construction purposes. So, if correlation is part of your investment decisioning, don't be surprised when it does not work. It's just an efficient market doing its job!
So, let's think how "Alts" should work for you. Here is our perspective:
For a truer alt, look to illiquid markets first, like private equity, collectibles, real estate, certain debt instruments, emerging markets, which can be generally inefficient relative to the liquid/developed markets.
Look for structural Alts, like insurance contracts that basically allow us to offload certain risks onto the insurance company. We highlighted such a product last month. This is a great play and because of the number of contractual differences between insurance companies takes some digging to figure it out but can be well worth it. We are thinking about it and so is Roger Ibbotson!
Another "alt", how about sub-investment grade debt? Lower liquidity, equity-like returns, less rate sensitivity, and collateral-backed. Can be complicated but therein lay the alt flavor and inefficiency that can be worked.
Leverage, now there's a 8 letter word to many. Not for the uninitiated or those who rely on correlations (risk parity funds!). You can easily lose your shirt here (just like futures, commodities, leveraged ETFs). But, if you can design a portfolio construct with the right return distribution (big IF here), then the injection of some leverage can be a return source that creates an alt-like return stream. If returns of the general equity market recede back to historical averages, leverage could be the only controllable mechanism to maintain higher double digits returns. If it works for banks, why not for investors?
Finally, in liquid markets, inclusive of equities, currencies, investment grade fixed income, commodities, futures, options, your chance to find a sustained "Alt" is slim. We argue that our ARBi elevated rebalance rate is a source of "Alt" in this world and based on historic results and third-party analysis, it appears so. And, if market volatility remains at levels of 16+ for the foreseeable future, our form of Alt in a liquid market may be able to further demonstrate its uniqueness and value to our investor portfolio constructs. That said, the point is to find some truer alt flavor and mix it into your portfolio.
So, get smart, diligent and some real alts into your world!