Recently, we wrote in praise of the commodities — that is, a longer broad-based futures portfolio — as the best inflation hedge of the year. However, commodities may not be the best risk diversifier for long-term investments.
Let’s not get ahead of ourselves. There are several alternative investment ETFs that can be used to complement a portfolio and reduce equity market exposure. We regularly track the 14 largest funds to assess the state of the sector. Half of this universe gave a positive return for the first quarter of 2022:
A quarter or a year is one thing, but a year doesn’t make a portfolio. The Alt universe looks a little different when viewed through the lens of a five-year cumulative return. Except two of our 14 ETFs are now above their March 2017 values, with the top five funds growing an average of 65%. However, risk diversification is not really measured by returns alone; The volatility and correlation figures are big in that calculation.
When we consider a traditionally balanced portfolio (60% equity/40% fixed income), we find that the addition of bonds to equity exposure provides a diversification advantage. We are all taught that making room for a fixed income allocation in an equity portfolio can significantly reduce overall volatility. And, empirically, this is true.
how so? Well, given the isolated volatility of an equity (the SPDR S&P 500 ETF: SPY) and a fixed income (the iShares Core US Aggregate Bond ETF: AGG) exposure, the 60/40 mix should have cranked out a weighted standard deviation of 10.81% over the past five years. However, Synergy only worked to produce a true volatility of 9.51%. This gives us a diversification ratio of 1.14 (10.81% to 9.51%) for a bond-added portfolio.
Now, adding an alternative exposure to this balanced asset mix — by meeting the 10% allocation from the equity side of the portfolio — should result in a diversification ratio greater than 1.14 to be considered practical.
By this measure, all of our top five alt ETFs provided some diversification benefits, some substantially and some, well, not that much.
An exposure to gold, revealed through SPDR Gold Shares (GLD) Offers the greatest diversification advantage, due to its near-zero correlation to stocks (0.03) and its modest correlation (0.33) to bonds.
Also note the volatility (relatively low) and Sharpe ratio (relatively high) of the gold-enhanced portfolio. Gold for most of the period was the yin to the stock market’s yang, producing a smooth ride on the most sought after portfolio awards.
Holding gold in your portfolio over the past five years may not have made you the richest of the most savvy investors, but you’ll probably be sleeping better when the equity markets plunged at the start of the COVID-19 pandemic.
The metric that reveals the insulation of a portfolio against downside volatility is the Sortino Ratio. Unlike the Sharpe ratio, which compares an investment’s return to its total volatility — both up and down — the Sortino version only penalizes negative divergence. The GLD-enhanced portfolio earned a table-topping Sortino ratio of 1.70 over the past five years. An investment approaching the Sortino Ratio 2.00 is generally considered very good.
Next best, at 1.58, is the Enhanced Portfolio with Invesco Optimum Yield Diversified Commodity Strategy Number K-1 ETF (PDBC.)), a long-only portfolio of diversified commodity contracts optimized to mitigate the adverse effects of trading along the futures curve.
to link SPDR Bloomberg Convertible Securities ETF (CWB) yields a Sortino ratio of 1.57 for a balanced portfolio. CWB is a market cap-weighted portfolio of convertible bonds and convertible preferred shares.
sadly the effect of contributing Global X NASDAQ 100 Covered Call ETF (QYLD) To A balanced portfolio is actually negative. A 60/40 mix of SPY and AGG yields a 1.55 Sortino ratio, but a 10% carve-out for QYLD drops the portfolio’s Sortino ratio to 1.49.
What’s worse is that the portfolio has grown Vanguard Real Estate ETF (VNQ) A lower 1.44 draws the Sortino ratio down. Vanguard’s portfolio includes a diverse mix of over 160 domestic real estate investment trusts.
There is no guarantee that diversification through alternative investments will make it easier for investors to move forward. Still, we’ve always favored innovation (the classic commercial – Chevrolet’s “Jet-Smooth Ride” – 1961 – watch YouTube) over the obstacles and setbacks in the road ahead.
Brad Ziegler is Wealthmanagement’s Alternative Investments Editor. Previously, he was the head of marketing, research and education for the Pacific Exchange (now NYSE Arca) options market and the iShares complex of exchange-traded funds.