When financial assets are strongly appreciating, diversification (to put it mildly) looks like a Fool’s Game. Speculative assets during such periods can hold unmistakable allure. Whether cryptocurrencies in 2020 or “dot com” stocks in 2000, investors ask, “Why didn’t my advisor diversify my portfolio like that?”
The corollary for investors in alternatives might be, “Why did I invest in this (sleepy) infrastructure fund, or in this yield-focused private credit vehicle?”
Altera recognizes that alternatives are unlikely to be a portfolio’s short-term “star”. It is easy to forget the investment case for, say, that infrastructure fund. That’s not to say that such investments don’t have clear appeal, tending to have a sizable income component and a chance at some appreciation, too. And as an illiquid asset, their value would be expected to change little over any short time period.
But stable income seems dull until markets become volatile. And future appreciation isn’t truly appreciated until it we actually see it.
In 2021, we might welcome a few assets with a lower correlation of returns with the public markets. Volatility has returned, and a vicious tug-of-war is occurring between richly priced growth stocks and the “value” shares that have underperformed since 2008. Some past winners have lost half their value from recent highs.
Meanwhile, today’s investors may be taking more risk, having allowed portfolios to drift to higher equity allocations. It is also well documented that investors’ “home bias” has continued to grow. And portfolio concentrations could possibly be higher than any time in recent memory. Five large cap tech stocks now account for 20% of the S&P500 and may comprise a significant part of many investor portfolios.
The question is this: Can volatility remind us to keep our eyes on the actual prize? Can it help us remember to play the long game of building wealth by compounding attractive long- term returns across a variety of less-correlated assets?
The challenge, of course, is in our basic human nature. Investors look at their portfolios and may not see concentrated risks across securities whose returns are driven by similar factors. Instead, they notice that some alternatives can take years to get fully invested or see the “J-curve” where initial periods show losses, not gains. Diversification requires patience in comparison with a robust market environment — especially when the sequence of returns for “alts” is weighed more to the future and less to the short term.
On the other hand, if those alternative investments can generate equity-like returns without equity market risk, then the long-term investor is the winner with a smoother ride and the returns that they need. Seven years in, that infrastructure investor may have gotten most of his or her capital back. And, by year eight and nine, portfolio exits may be occurring, with lumpy returns that make few headlines, but that can swell account values with little fanfare.
Human nature is unlikely to change, but with the mindset of a business owner, we can see the compounding at work (and not just the excitement of ups and downs) across our portfolio of “businesses”. Or, when we think like a pension fund manager, taking a truly long-term perspective, we can see how a balanced array of diverse return sources can make it more likely that we will achieve our financial goals.
In other words, we can be in tune with the actual workings of our portfolio. If volatility is what eventually gets us to have this mature look at our investments, then that not-so-gentle reminder is valuable indeed.