Will Alternatives — Private Equity, Real Estate — Boost Your Portfolio?

As investors are well aware, both stocks and bonds have tumbled this year. The S&P 500 has lost 13% and the Bloomberg Aggregate bond index has shed 9%.

Bonds are supposed to be a hedge for falling stocks, but obviously they haven’t acted that way this time around. So what’s an investor to do?

Some experts recommend alternative assets – real estate, private equity, hedge funds, commodities, and more. All these investments are available to retail investors in some form. But do they really provide diversification, boosting returns and reducing risk?

Veteran Morningstar analyst John Rekenthaler offered insightful analysis.

total return

He looked at the total returns for alternative fund categories for the 15 years through January 2022. Only one of them — real estate — beat an intermediate core bond fund, which is their competition.

Real estate had an annualized return of about 5%. All the other alternative strategies returned about 3% or less.

“That’s a disappointing showing,” Rekenthaler noted. “Over 15 years, only one of the nine investment alternatives outgained that which they sought to replace.”

In addition, “the winning real estate category was several times more volatile than were intermediate core bond funds,” he wrote.

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Thus, “from a risk-adjusted point of view, every one of the alternatives trailed the simple, safe, and obvious choice.”

In addition to low returns, the alternative funds provided little diversification, Rekenthaler said. He researched the alternative categories’ correlation with a balanced portfolio – 60% stock funds, 40% bond funds.

“A negative score would be ideal, indicating that the category tends to move the opposite way of conventional assets,” Rekenthaler said. “Failing that, a low positive score would be useful.”

Problematic correlations

The results: “Oh, dear,” Rekenthaler said. “Not only were all the scores positive, but seven of the 10 categories recorded correlations of at least 0.6.” A score of 1 indicates total correlation.

Finally, he examined Sharpe ratios, which measure risk-adjusted return. Comparing portfolios with 60% stock funds, 20% bond funds and 20% belonging to an alternative category, intermediate bonds beat all nine alternative categories.

Rekenthaler didn’t look at cryptocurrencies, but their returns have been checked, their volatility is high, and so are their fees.

In any case, “the verdict is lamentably clear,” Rekenthaler said. “The common, cheap, and everyday solution outdid every one of Wall Street’s esoteric, expensive, and specialized responses…. I see no reason why the future will bring a different result.”

It’s hard to argue with him. Financial advisers have plenty of incentive to push alternative assets on their clients. Doing so garners hefty fees. Advisers now have another product to sell in addition to stocks and bonds.

But alternative investments don’t appear to do a lot of good for portfolios.