Improving portfolios’ equity diversification with hybrid alternative assets
Traditional fixed income allocations are proving less beneficial in mitigating portfolio volatility and downside risk.
Nontraditional asset classes we call “hybrid alternatives,” with some characteristics of equity and some of fixed income, may improve portfolios’ equity diversification and offer downside protection, helping provide stability during market stress.
We examine two hybrid alternatives: diversified portfolios of hedge funds, and “core” alternatives (real estate, real assets and alternative credit). Although they are moderately less liquid than publicly traded securities, they have a range of other attributes that make them potentially beneficial diversifiers.
Investors in these two categories may improve diversification even further by creating a portfolio of diversified hedge funds or diversified core alternatives. We call this “diversifying the diversifier.”
Diversification is a critical consideration in portfolio construction. To mitigate public equity risk, portfolio construction historically relied on a core fixed income allocation to potentially dampen portfolio volatility, provide stable income and improve diversification over time. However, amid low and rising interest rates and rising inflation, combined with higher volatility across global equity markets, core fixed income has exhibited reduced diversification benefits.
In this environment, the way to mitigate equity risk may lie in nontraditional asset classes. Here, we examine the opportunity in hybrid alternatives—investments that exhibit equity-like and fixed income-like characteristics.
Hybrid alternatives: A range of asset classes may lower portfolio volatility
Hybrid alternatives (alts) encompass a wide range of asset classes with the potential to decrease portfolio volatility and reduce equity beta. Adding hybrid alternatives may have the added benefit of improving returns, particularly when funded from fixed income allocations. In sum, hybrid alts’ attributes may lead to a more resilient all-weather portfolio.1
We categorize hybrid alts in two broad categories: diversified hedge funds, and core alternatives. By core alternatives, we mean a range of asset classes including real estate, real assets and alternative credit (sometimes called private credit).
Alternative credit is an asset class that we increasingly see as a portfolio essential, crucial to an asset allocation framework, although these assets are often less well understood than traditional investments and generally less liquid. Different hybrid alts have differentiated risk-return profiles and so may provide varying degrees of equity diversification.
Hybrid alternatives: How diversification characteristics differ across subcategories
A broad and growing menu of alternatives asset classes may benefit portfolios in a range of ways. Diversification, our focus here, is just one.
Exhibit 1 shows how two types of hybrid alternatives—a variety of hedge funds, and core alternatives—may help lower public equity beta. (Public equity beta is used as a proxy for risk, since public equities are typically the largest contributor of risk to a portfolio.)
A range of hedge funds and core alternatives may provide a source of portfolio diversification
Exhibit 1: Quality of potential diversification benefits from hybrid alternatives over a 15-year period
What key attributes drive hedge funds’ diversification potential, and what are their hybrid characteristics? (Here we refer to macro, relative value, diversified and event-driven hedge funds.) The answers are their managers’:
Flexibility to take long and short positions, reducing drawdowns in periods of equity market volatility
Ability to tactically navigate exposures and position allocations to decrease risk during periods of market stress and to capture upside return opportunities in times of dislocation
Active management of leverage and gross vs. net exposure, which further helps reduce risk in stress scenarios
Ability to invest in local economy drivers and/or less trafficked, typically uncorrelated market segments, which can improve diversification because of these segments’ independent return drivers
Importantly, hedge funds span a broad spectrum of investment styles, and each approach offers varying degrees of diversification potential. To make the most of the opportunity, and to avoid compounding a portfolio’s existing risk exposures, investors considering hedge funds for diversification should understand the investment implications of each hedge fund’s strategy, investment objectives, risk profile and scope of investments—both on a stand-alone basis and in the context of their existing portfolio allocations. Any investment constraints should also be taken into account.
Core alternatives—here meaning core real estate, core real assets and core private credit—have hybrid attributes that create their diversification potential. These include:
Forecastable, often contracted, income that is the foundation of total return and produces a more stable long-term return profile
Return drivers that are often local, decreasing these assets’ correlation to the global equity market and broad macroeconomic factors
Longer-term investment horizons, which can lower the impact of short-term market fluctuations
Exposure to high credit quality counterparties, decreasing potential counterparty risk
Higher quality sector allocation, reducing exposure to more cyclical sectors
Lower leverage than non-core alternatives (such as private equity and opportunistic real estate), which can reduce the volatility of returns and decrease drawdowns during periods of market stress
Embedded inflation sensitivity, providing returns that can be more resilient, in real terms, across different interest rate and inflationary macro environments
Potential for improved environmental, social and governance (ESG) characteristics, given the assets’ nature and investment profile
The importance of manager performance
An important consideration when implementing an investment in a portfolio of hedge funds or core alternatives is manager dispersion. Comparing our two categories, hedge funds can have significantly greater manager dispersion than core alternatives (Exhibit 2). This makes manager selection a significant factor when building an allocation to hedge funds, with possibly material implications for long-term outcomes.
Core alternatives exhibit lower levels of manager dispersion, but there is significant dispersion across core alternatives categories, creating an opportunity for active management.
Implementation is an important consideration when allocating to diversified hedge funds or core alternatives
Exhibit 2: Manager dispersion is lower within core alts; hedge fund manager dispersion is 5x wider
Because of the inherent investment attributes of hedge funds and core alts, these investments have the potential to lower both return volatility and equity market beta. When included as part of a broader portfolio, the result is potential diversification and differentiated returns vs. a stand-alone traditional 60/40 portfolio (Exhibit 3).
Exploring hybrid alts' impact on a traditional 60/40 portfolio
Exhibit 3: Impact on a 60/40 portfolio of adding diversified hedge funds or core alternatives
Diversifying within nontraditional asset classes can further improve the diversification opportunity
Although an allocation to a stand-alone category of hybrid alternatives may provide varying degrees of diversification, the potential is notably greater when the allocation is broader. A broader allocation to hybrid alts may benefit from the low correlation among many of these asset classes, resulting in a more resilient, all-weather portfolio. We call this “diversifying the diversifier.”
This can be implemented on multiple levels, including:
Strategic portfolio construction. Actively and appropriately sizing and managing investments using the full suite of hedge funds and core alternatives asset classes in a targeted way can contribute to improved diversification.
Active management and active asset allocation. Actively adjusting exposures can help an investor further improve the diversification opportunity by better capitalizing on the differentiated sources of risk and return across hybrid alternatives as the market environment changes.
The main trade-off in both these cases: moderately less liquidity than a public markets portfolio.
Hybrid alternatives potential for downside protection during severe market dislocation
Diversified hedge fund and diversified core alternatives portfolios may provide stronger downside protection than an individual hedge fund or the simple average of the components included in the respective diversified portfolios. Exhibit 4A quantifies the opportunities of differently constructed hedge fund portfolios. Exhibit 4B does the same for various diversified core alternatives portfolios.
Strategically allocating across a mix of strategies may best capture their long-term diversification potential
Exhibit 4A: Expected volatility and downside risk of a diversified hedge fund allocation
Exhibit 4B: Expected volatility and downside risk of a diversified core alternatives allocation
In addition to providing long-term strategic benefits, a diversified hedge fund portfolio or diversified core alternatives portfolio can potentially mitigate short-term declines in public markets. Reducing max drawdowns during periods of high market volatility may enhance portfolios’ long-term risk-adjusted return. An example was the 20% decline in global equity markets in 1Q 2020 (the coronavirus crash), which affected the majority of asset classes around the world as the global economy ground to a halt due to the rapid spread of COVID-19 and the ensuing lockdowns (Exhibit 5).
During the pandemic crisis, hybrid alternatives—diversified hedge funds and core alternatives—smoothed portfolio performance
Exhibit 5: Performance of asset class indices globally vs. hybrid alternatives
During the early pandemic environment of severe dislocation, a broadly diversified core alternatives allocation would have declined about 3% and diversified hedge funds declined about 8%. Furthermore, this benefit of smoothing volatility through a diversified hybrid alts allocation is beyond what could have been achieved with any individual hybrid alternative—highlighting the improved short-term portfolio resilience that can arise from “diversifying the diversifier.”
Risks—and risk mitigation through diversification
While diversified hybrids may provide diversification benefits, it is important for investors to also consider the investment objectives, risk profile and other attributes of each individual component. For many alternatives, the most significant trade-off for these benefits is moderately less liquidity than in traditional public markets.
Investors in private markets should also be mindful of other ways they differ from public markets, such as less frequent valuations and reporting (typically, monthly or quarterly); less transparency into underlying investments; and idiosyncratic risks in each respective sub-asset class/investment. (Idiosyncratic risks are, however, partially mitigated by investing in a broadly diversified portfolio of hybrid alternatives rather than more concentrated exposures.)
For investors today, faced with rising interest rates and rising inflation combined with higher volatility across global equity markets, diversifying equity risk is an important consideration. A diversified, actively managed portfolio of hybrid alternatives, such as a diversified portfolio of hedge funds or core alternatives, may lower equity beta and decrease portfolio volatility, potentially making portfolios more resilient.