On Alternatives

"Alternatives" has been one of the buzzwords floating around my circles as of late. I'm always suspicious when some new fad pops up, but in the case of alternatives, I'm more amused than anything else; they've been around for quite a while, but as earning yields and interest rates (and, thus, future expected returns of stocks and bonds respectively) fell over the last couple decades, they started moving from "valuable" to "necessary". I'm more of the school of thought that says "if an asset class is ever good, it's always good", but I won't complain at an opportunity to address an important topic!

Of course, the foundational question is: what exactly is an alternative investment? I'll spare you the Investopedia definition...but I won't spare you the recap of the fundamentals of portfolio design. You can skip over the bits you already know, but make sure you know it -- this stuff is important!

Uncorrelated asset classes and portfolio design

First, let's go back to the fundamental principals of portfolio design, according to Modern Portfolio Theory. Contrary to the kind of strategy you'd find on e.g. stockpicking websites, constructing a portfolio via MPT doesn't mean gathering assets that you think will "do better" than other assets, trying to find the next five- or ten- or twenty-bagger and then selling it at its peak before finding the next one. Rather, the underlying goal of MPT is to design a portfolio with the highest long-term returns for a given amount of volatility.

A diversified portfolio's returns can actually be quite well-modeled using a Gaussian distribution ("bell curve"), with just a couple of tweaks (some skewness and kurtosis, if you want to get specific). You can move the distribution's center to the right -- increase the expected returns -- but generally only by making the distribution wider -- increasing the volatility. This is why establishing your risk tolerance and risk capacity is the first step to designing a portfolio; you've got to figure out how much volatility you're willing to take!

What if, though, we could narrow the distribution without decreasing the expected returns? This is where uncorrelated asset classes come in. The idea is relatively straightforward: if you have asset classes that have a high inflation-adjusted return but aren't correlated with each other, then when one is going down, the other is just as likely to be flat or even going up. Thus the total volatility of the portfolio is actually less than that of the individual asset classes, because they're moving out of sync and thus dampening each other's volatility.

Stocks and bonds are an excellent example of this; their correlation coefficient is close to zero, meaning that they generally move out of sync. Of course, that's not always the case; early 2022 saw both stocks and bonds fall simultaneously, irritating many investors and investment managers (including myself)!

However, stocks and bonds aren't the only asset classes out there, and the name given to these "alternative" asset classes is...well. You're smart; I won't spell it out for you.

Alternative #1: Real Estate

No surprise here; real estate has been around since before either stocks or bonds, and is generally the first thing people think of when they think of alternatives to the aforementioned securities. And it's a good one; the expected returns are certainly higher than inflation, and the correlation is neutral to both stocks and bonds.

The tricky part lies in actually investing in real estate. Most people have two options: either directly invest in real estate, which generally involves a huge down payment and/or a mortgage tied to a single, non-diversified investment, or invest in a Real Estate Investment Trust. Now, REIT's are quite nice, being as liquid as anything else on the stock market; the only issue is that they've got a pretty high correlation with stocks, behaving more like a "sector" of the stock market than something wholly apart, which defeats the ideal purpose.

So what's the solution? Well, there are apps such as Fundrise that look to allow direct investment in real estate, as does TIAA-CREF's real estate fund (only available in TIAA-CREF retirement accounts). Seaborn solves this problem by combining REIT's with a private equity real estate partner, allowing its clients to invest directly in individual commercial real estate properties alongside a more diversified real estate portfolio.

Alternative #2: Commodities

If you've been around a while, you know that I don't actually recommend that clients hold commodities in their portfolios. Are they a great diversifier? Sure; they're volatile as heck, but they're not correlated with either stocks or bonds. The problem is that almost by definition, the expected return of a diversified commodities investment is inflation, so the inflation-adjusted return is zero!

Now gold is sort of a commodity unto itself; because its price seems to be driven as much by sentiment as anything else, it's all over the map compared to other stores of value -- but I'm not a fan of building portfolios based on the "bigger fool" theory, so I tend to leave it alone.

That said, you can make an argument for adding a dollop of commodities to your portfolio, reducing the returns but potentially reducing the overall volatility. The inefficiency of commodities themselves is so high, though, that I don't recommend it. That said, if you want to, you can check out collateralized commodities futures as an interesting way to do so with a nonzero expected inflation-adjusted return, due to the yields on the collateral.

Alternative #2a: Cryptocurrency

Let's not ignore the elephant in the room, shall we? I'm going to call this alternative "2a", rather than "3", because cryptocurrency behaves remarkably like gold in two major respects: it's a "store of value", hedging against inflation by virtue of the fact that there's a (semi-)fixed amount of it, but it's also largely driven by sentiment and speculation, as evidenced by what its prices do whenever Elon Musk sneezes. Could it go "to the moon?" Sure. Could it go to zero? Also sure. Like commodities, I'd include no more than a dollop, if that, and I'd be diligent about rebalancing your portfolio, lest your entire portfolio become subject to Mr. Musk's whims!

Other "alts"

While these are some of the Big Ones, there are many other alternatives out there. "Alternative lending", like Lending Club, has an interesting lack of correlation with other bonds. Reinsurance -- think of it as the insurance that insurance companies take out -- is also interesting. Selling options is a way to capture the "variance risk premium"; selling call options is sometimes likened to selling lottery tickets.

Private equity is often touted as an alternative investment, though there's good research that indicates that it behaves in a manner similar to small-cap, highly-invested growth stocks; it just doesn't look as volatile because it's not revaluated every second the way public securities are! (Also, remember that bit about selling lottery tickets? Private equity is basically buying them...and just like the real lottery, while you could strike it rich, the odds aren't in your favor.)

One alternative that's particularly interesting to me: there are long-short portfolios that actually invest directly in some of the factor premia across several asset classes, including stocks, currencies, and commodities, all at the same time! Because these asset classes are uncorrelated with each other, and the factors are also uncorrelated with each other, and obviously expected to yield a positive real return, these could make a great addition to the portfolio! However, they're not cheap, and factor premia sometimes trail the market (e.g. the crazy runup in growth stocks in the late 90's and 2010's); they're no silver bullet!

The list of alternatives is long and ever-growing. However, the trouble with most alternatives beyond real estate and commodities is that they are opaque, complex, illiquid, and/or expensive. Be extremely careful when adding these to your portfolio, or they could blow up in your face!

How we invest in alternatives at Seaborn

Because we take a very research-based approach to investing, we don't go crazy with alts at Seaborn. We have a discrete allocation towards real estate, including select private equity real estate opportunities (probably the highest-earning asset class in our portfolios). We eschew commodities in general, and gold and crypto in particular. Beyond that, we're always keeping an eye on the landscape, especially as the fees for "liquid alts" fall. Anything research-based -- like those factor premia derivatives we mentioned earlier -- is something we're particularly interested in.

As for allocation: each alternative holds a relatively small piece of the portfolio, but as we add more that are uncorrelated with stocks, bonds, and each other, the overall allocation to alternatives will rise. Meanwhile, we don't want to put too many of our eggs in one asset class basket.

While I hope this was educational (and not too boring), all this is just the tip of the iceberg; I'm happy to nerd out in the comments of FB/LinkedIn if you've got any further thoughts!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.