Alts Are Here. Now, It’s Time to Diversify

“Don’t put all your eggs in one basket,” is a piece of advice that’s easier to give than to follow.

Since 2019, stocks and bonds have often moved in tandem, with the diversification benefits of bonds especially weakening when volatility rises, according to a recent analysis by the International Monetary Fund. But spreading your money out across different types of assets is still an important risk-management strategy for investors. Enter liquid alternative investments that experts say are offering some protection against large losses in the stock market, including equity market neutrals and commodities. 

“It does seem like the US equity market keeps chugging along, but it may not continue that way forever,” said Amy Arnott, a portfolio strategist for Morningstar. “So it’s always helpful to have exposure to some assets that have different performance characteristics that could help buffer your losses if the market does go down.” 

The Sturdy Baskets 

If you’re looking within traditional liquid alternative funds, one category that really stands out as a diversifier is equity market neutral strategies, which balance long and short equity exposure in an attempt to isolate stock-picking skills without taking on as much overall market risk, Arnott said. Over the last three years, their correlation has been -0.3, which is lower than any other Morningstar fund category. 

Commodity funds have also been strong diversifiers, with slightly negative to close to zero correlation with the overall market over the past three years. Arnott suggests investors have long-term holdings in a diversified commodity fund with exposure to both energy-related commodities and precious metals like gold. Managed futures funds, which go long on asset classes that are going up and short on those that are going down, are another good pick, she added. 

These alts are appealing to advisors: 

• Joon Um, an advisor with Secure Tax & Accounting, said his top choice of alts that offer diversification is managed futures because they can profit from trends across commodities, currencies, interest rates and equities, giving them the potential to perform differently than traditional stocks and bonds. 
• Jon Lapp with Haven Financial Advisors said his preferred alternative assets have been primarily precious metals over the past few years. “We like gold and silver as a hedge,” he added. “The significant growth of both of them has caused us to rebalance several times, to capture the gains while making sure it remains a complementary holding instead of a core one.” 

Risk Benefits Over Returns. Diversification plays often don’t come with the best returns. Equity market neutral funds, for instance, have annualized returns of about 4.1% over the past 10 years, according to Morningstar data. “It’s important for advisors to communicate to their clients, if they do want to add positions in those funds, why they’re doing that and that you probably shouldn’t expect the highest returns,” Arnott said.