Look What’s in the Toolbox…Talking Liquid Alternatives

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Look what’s in the Toolbox….Talking about Liquid Alternatives

With the stock market recently reaching new highs, varying explanations abound. One explanation that is hard to ignore is that the Fed’s zero interest rate policy has held bond yields below the true rate of inflation and consequently is forcing investors to take more risk to make any kind of return. With many companies’ dividend yields in excess of the 10 year bond yield (still below 2%), investors are putting cash into the stock market., driving prices higher.

But is that all there is to asset allocation? Because I can’t earn any yield in bonds then I should buy stocks? That would be true in a world without fear…a purely greedy world if you will. But there is still plenty of fear out there, with everything from budget sequesters to continued high unemployment and a seemingly dysfunctional federal government to feed our nightmares. Yes asset allocation involves more than the simple trade-off between expected returns of broad asset classes. It must factor in risks, especially when all seems good.

If bonds are viewed as being unattractive, our asset allocation models will drive us into stocks. Regardless of how much you may loath bonds at the moment, increasing the allocation to stocks will heighten the risk of any portfolio, as the majority of portfolio risk derives from equities. In order to mitigate this risk, investors have bought preferred stock, high yield bonds, global bonds and bank loans, which all carry more risk than straight high grade bonds but less risk than equities. They have bought real assets, such as commodities and real estate (not recommended for senior living operators who already have a lot of real estate equity risk) because those returns are less correlated to equity returns. And increasingly they are buying a group of strategies that has been called “alternative investments”, also called diversifying strategies. In the past these strategies were available only to “qualified” investors who were willing to forego liquidity, transparency and traditional policy limitations to portfolio management in exchange for the hope of non-correlated returns. Now many, but not all, of these strategies are becoming available in mutual fund format. As mutual funds, these vehicles offer daily liquidity (thus the tag “liquid alternatives”), normal mutual fund transparency and limitations on the amount of leverage used in the funds.

Most of these strategies have return expectations that are greater than bonds but less than stocks with risk levels that are higher than bonds but lower than stocks. They represent what Rob Arnott of Research Affiliates calls the “Third Pillar” of portfolio construction, because their returns have had lower correlation to the traditional asset classes and their portfolios are constructed more from the standpoint of risk budgeting than traditional portfolios. Some of the portfolios aim to beat the S&P on a risk adjusted basis on one end of the spectrum while others aim to beat inflation by a comfortable margin on the other end of the spectrum.

If fixed income is a concern going forward, liquid alternatives should be a topic of study.

About Jim Jeffery, CFA

Jim Jeffery, the founder and principal of Jeffery Asset Management has joined Solaris Advisors LLC as Managing Director where he will lead the non profit senior living effort. Jim is a Chartered Financial Analyst (CFA) with more than 20 years experience in the financial services industry. Have a question about your financial plan? ASK JIM

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