The Alternative Portfolio: Diversifying Away From a Traditional Allocation
by Charles Rotblut, CFA
“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.
In this article
- It Starts With Correlation
- The Basic Rules
- Creating an Alternative Portfolio
- Testing the Diversification Benefits
- Portfolio Performance
- Invest in Alternative Assets or Not?
- Past Journal Articles on Alternative Investments
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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.
It Starts With Correlation
One of the most basic building blocks for any portfolio is correlation. In terms of investing, correlation shows how similar the returns of two asset classes are. Correlations of, or near, +1.00 imply that assets experience the same type of return characteristics. Correlations of, or near, –1.00 imply that assets tend to have completely opposite return characteristics. Correlations of, or near, 0.00 imply that the assets have different return characteristics. Two assets with a correlation near +1.00 will typically move in the same direction and will experience similar magnitudes of change in price. Assets with correlations near 0.00 will have different returns: As one asset moves up in price, the other may move up in price, move down in price or stay unchanged. There is no relationship between the return characteristics.
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Discussion
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".
posted 9 months ago by Ed from New Jersey
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.
posted 9 months ago by Morton from North Carolina
There is a great deal of information here that should be closely evaluated as to how it fits into your financial situation and goals.
posted 8 months ago by Floyd from Florida
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!
posted 8 months ago by David from Washington
Teck, I had Morningstar specifically run the data for this article. -Charles
posted 8 months ago by Charles Rotblut from Illinois
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.
posted 3 months ago by Hwan Perreault from Washington
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
posted 2 months ago by R Herrera from Texas
