- Equities: Advisors are maintaining an overweight in U.S. equities. U.S.-China trade tensions and weaker-than-expected economic data remain concerns.
- Fixed income: While we see a gradual shift toward higher quality core to mitigate the impact of stock market volatility and potential drawdowns, advisors are remaining diversified, with allocations to core complement and extended sectors, given the possibility of further rate hikes.
- Multi-asset: Moderate and conservative allocation strategies predominate as advisors look for a balanced approach in response to bouts of market volatility and trade tensions.
- Alternatives: While alternatives remain a small allocation in portfolios, certain styles are growing in popularity as advisors look for ways to reduce risk without adding interest rate sensitivity.
- Our equity alternatives case study shows how options-based equity investments can potentially provide protection in a downturn.
An “alternative” approach for mitigating the impact of late-cycle volatility
Minimizing the impact of market volatility on client portfolios is the greatest concern for 60% of advisors, according to data captured through our Portfolio Insights (PI) service. This is not surprising, given the domestic, geopolitical and policy uncertainties surrounding markets in the late stage of this economic cycle.
Historically, advisors have positioned portfolios for uncertainty and a potential market downturn by simply increasing allocations to higher quality core fixed income. But with the Federal Reserve raising rates, advisors are searching for a different solution—an “alternative” approach to mitigating portfolio volatility.
What types of alternatives are gaining popularity, and why?
Among the over 3,700 portfolios our PI team analyzed in 2018, less than one-third had an allocation to alternatives. However, our work with advisors indicates a keen interest in alternatives and, we believe, an opportunity to provide further education on different alternative styles and their portfolio implementation.
As we dig a little deeper into our data, a picture of the alternative styles that may best align with advisors’ current needs begins to emerge. Strategies within two Morningstar Alternative categories,1 Market Neutral and Options-based—typically used to manage equity beta exposure and as a buffer against market volatility—have gained relatively strong followings. They accounted for approximately 50% of the alternative assets held in portfolios submitted to our team in 2018, and also had the highest net inflows among Morningstar Alternative styles.
From our perspective, this is a clear indication that advisors are looking for much more defensive approaches to gaining equity-linked exposure. In each of these categories, the most widely used investment had a beta to the equity market of 0.5 or less.2 Additionally, these investments have demonstrated an ability to provide positive total returns and significantly outperform traditional fixed income in rising rate environments.3 These strategies are also relatively low cost, with an average net expense ratio of 0.81% vs. 1.98% for the Morningstar Alternative category as a whole.
Dampening portfolio volatility with equity alternativesThe final quarter of 2018, in which the S&P 500 had a -19.36% pullback, was quite painful for investors. We used this period in a case study illustrating how an allocation to alternatives may help reduce a portfolio’s sensitivity to market volatility. Insights from our PI team and J.P. Morgan Global Alternatives’ implementation framework guided our analysis.
Let’s start by tackling the framework’s three critical questions:
1. Which strategies should I invest in?
We chose U.S. Options-based equity strategies, since they are a favored style among advisors and can serve as efficient beta reducers.
2. From where should I fund my allocation?
Given the goal of reducing equity risk, we chose to fund the equity alternative by reducing traditional S&P 500 exposure.
3. What would be the right allocation to alternatives within my portfolio?
This depends on the client’s objectives and time horizon. We review multiple allocations to help understand each one’s potential benefits.
A 10% to 20% allocation to equity alternatives can lessen portfolio downturns in volatile markets
EXHIBIT 1: Returns for 60-40 portfolios with different allocations to equity alternatives,* funded from a traditional 60% equity exposure (September 21, 2018– December 24, 2018)
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