The Alternative Portfolio: Diversifying Away From a Traditional Allocation

by Charles Rotblut, CFA

The Alternative Portfolio: Diversifying Away From A Traditional Allocation Splash image

“How can I construct a portfolio that is capable of producing returns different than those of the S&P 500 and long-term Treasuries and that is also capable of warding off the threat of inflation?” This is what many AAII members have asked me for.

The good news is that I was able to create such a portfolio. In fact, over the time period tested, its performance topped that of a traditional large-cap/long-term bond portfolio. The portfolio can be replicated using exchange-traded funds. Unfortunately, this alternative portfolio is more volatile than a traditional portfolio comprised of large-cap stocks and long-term bonds. Furthermore, the time period used to test the portfolio may not be long enough to show whether its performance advantage will last well into the future.

The alternative portfolio does complement a more traditional portfolio. It includes a mix of assets that provide diversification benefits to a traditional portfolio and enhanced returns over the time period studied. The benefits come at the cost of increased volatility, however. Thus, the alternative portfolio’s best use may be as a supplement to, rather than as a replacement of, a more traditional portfolio.

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Charles Rotblut, CFA is a vice president at AAII and editor of the AAII Journal. Follow him on Twitter at twitter.com/charlesrotblut.


Discussion

Ed from New Jersey posted about 1 year ago:

Those looking for an alternative portfolio should consider Harry Browne's "Permanent Portfolio".

Browne developed what he thought was the optimal portfolio: 25% broad-based equity, 25% long-term Treasuries, 25% gold and 25% moeny markets. Browne believed that this was a "portfolio for all economies" (inflation, deflation, etc..).

Before you scoff, consider that this portfolio has an average 8-9% average annual return over the past 30+ years with lower volatility than the S&P 500.

Those interested in learning more can go to "crawlingroad.com".


Morton from North Carolina posted about 1 year ago:

Suggest you also consider Business Development Companies. They are like private equity cos but pubically traded and specializing in smallish companies. There is an EFT from Wells Fargo that tracks a BDC index by UBS, I believe. Interesting ideas.


Robert from Massachusetts posted about 1 year ago:

Very helpful article. Thanks.


Floyd from Florida posted about 1 year ago:

There is a great deal of information here that should be closely evaluated as to how it fits into your financial situation and goals.


Billy from Colorado posted about 1 year ago:

MUCH MUCH too long.


David from Washington posted about 1 year ago:

Thank you for the correlations! I have trouble finding them on the web and I'm not sure how to figure them myself. I think they are crucial to asset allocation decisions. I will be making some adjustments to my portfolio when valuations are right. A good, timely article. Well done!


Teck See from Illinois posted about 1 year ago:

are the correlations available from Morningstar?


Charles Rotblut from Illinois posted about 1 year ago:

Teck, I had Morningstar specifically run the data for this article. -Charles


Hwan Perreault from Washington posted about 1 year ago:

Where can I find more information on your comment:
MLPs do have the potential to create tax headaches, particularly if unrelated business income exceeds more than $1,000 a year from securities held within an IRA. (The specific tax that could be triggered is referred to as UBTI.)

An IRA is normally tax exempt until withdrawal.


R Herrera from Texas posted about 1 year ago:

Interesting, but I believe it requires more studying before going into it. Investing in the SSR stocks seems more fitting to me. Also, the portfolio in small stock and mutual fund/ETF are good choices. I'm interesting in Phil Towns's style of investment but will more to read about it.

Rey from Texas


Ed from New Jersey posted 8 months ago:

An alternative portfolio that generates higher average returns than the S&P 500 is good, but doing so with greater volatility is not good.

Diversification is supposed to lower risk and volatility, not increase it.


Michael Henry from Oregon posted 8 months ago:

Is the additional risk (volatility) worth it? I'm surprised you did not include the Sharpe ratios.

(10.8-1.5)/13.4 = 69%

(8.1-1.5)/11 = 60%

(7-1.5)/10.4 = 55%

Not only does the alternative portfolio provide higher absolute returns, it also provides higher risk adjusted returns.

For correlations try:
http://www.assetcorrelation.com/
Keep in mind that correlations tell you what happened in the past.

Yes?


Barry P. from Illinois posted 8 months ago:

To Michael Henry:
As a modestly knowledgeable investor, I would appreciate a little more explanation regarding how the alternative portfolio provides a higher risk adjusted return. I understand Sharpe ratio's, but can't figure why the $40,625 loss for the alternative portfolio is a better risk adjusted return than the $32,921 loss for the supplemental portfolio or the $28,809 loss for the benchmark portfolio. Thanks.
Barry P.


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