In part 1 of this series, I introduced a simple way to identify when we are in a bull or bear market. I then took this method and examined how certain types of hedge funds have performed in each of these market conditions. This week, I am going to use this information to propose a simple allocation strategy that an investor could employ in order to determine which alternative strategies (or alternatives) should be used and where to deploy them in the portfolio. First, let’s look at how most investors use alternatives today.

Most common use of alternative investments
Many investors and their advisors have approached allocating to alternatives as if they were a new asset class. In other words, the allocations to asset classes include stocks, bonds, cash and alternatives. One such allocation might proportionately decrease allocations to stocks and bonds in order to include a broad mix of different types of alternatives. For example, an investor with 60% stocks and 40% bonds might move to a mix of 48% stocks, 32% bonds and 20% alternatives (see chart below). For reference, I also included the use of fund of funds since they represent a professionally managed mix of alternatives.

As the analysis illustrates, using alternatives as a separate asset class is a pretty good method, although it appears that it is better to just choose a broad basket of equally weighted strategies rather than using a fund of fund strategy. However, in both cases the return was more desirable than the fixed 60% stock/40% bond strategy, and the volatility and capital drawdown were better.

The issue of allocating to alternatives in this way isn’t really the long-term characteristics of this approach, but rather the “opportunity cost” of using alternatives. To analyze this cost I calculated the annualized return of those months where using alternatives underperformed the simple 60/40 mix. On average the equally weighted mix of alternatives missed by 0.27% roughly 47% of the time. So, as an investor, you have to ask yourself if that opportunity cost is worth the additional 0.81% of annualized return. Some investors might just shrug at the benefits of including alternatives, especially when you consider the extra time needed to research, monitor and manage alternatives. This is why I think there is a better approach to managing your alternative allocations.

A dynamic approach to allocating alternative investment strategies
As I discussed last week, I think that investors would benefit from thinking about alternatives not as a separate asset class but as an extension of stocks and bonds. In fact, most alternatives use stocks and bonds but also include various hedging techniques. With that in mind, I looked at allocating to more equity-oriented strategies (HFRI Equity Hedged Index and HFRI Event Driven Index) when the market conditions indicator is bullish, and to more defensive strategies (HFRI Macro Index and HFRI Relative Value Index) when the market conditions indicator is bearish, taking from bonds in a bull market and stocks in a bear market. Specifically, my mix in a bull market is 40% stocks, 20% bonds, 10% equity hedged and 10% event driven. In a bear market, my mix is 20% stocks, 40% bonds, 10% relative value and 10% macro. This is referred to as the dynamically weighted allocation in the chart below.

As you can see, the dynamically weighted allocation approach delivers the best results pretty much across the board: highest return, lowest capital drawdown and highest Sharpe Ratio. Additionally, the opportunity cost is fairly comparable (although higher) to the fixed allocation method with an average monthly miss of 0.33%, but less frequent at 41% of the time. This is actually 16 fewer months of underperformance compared to the fixed allocation method. In this case, an investor would realize an increased annual return of 1.87%, which is probably worth the headache of the extra time and effort needed to manage the managers and allocations of the alternative strategies. This method is, of course, not a silver bullet. I would suspect that with some additional effort in refining the market signal and expanding the list to include the substrategies in the HFRI universe, an investor could probably improve returns, volatility and even the opportunity cost. However, I think this is a great starting point in developing your own approach to allocating to alternatives and I hope you find it useful.

See Part 1 of the series.