Why Your Old Alternatives Portfolio Should Kick the “Bucket”

To kick the bucket is an English idiom considered a euphemistic, informal, or slang term meaning "to die". (Wikipedia.org)

Asset Allocation is often thought of as filling buckets, I.e., the stock bucket or the bond buckets.  The buckets are subdivided further into smaller buckets such as the Large Cap bucket, the Mid Cap bucket, and the Small Cap bucket, which are divided further still into Value and Growth buckets.  This approach lends itself very well to passive and active management where fund managers hug benchmarks and never stray too far from said benchmark by design.

Then there are alternatives....

Alternatives are different from traditional investments in the sense that they are defined by what they are not as opposed to stocks and bonds which are defined by equity and debt.  The buckets for the alternatives are sometimes (and only sometimes) listed as the following: hedge funds/volatility; natural resources/real return; private equity; and private real estate.  Another bucket breakdown would be the following: real estate; commodities; timberland; farmland; private debt; private equity; venture capital; infrastructure; and hedge funds.  The lack of overlap is apparent and should give one some pause.  Which buckets and whose buckets are right/better?

The bucket approach in asset allocation makes more sense for smaller dispersions within an asset class.  Dispersion measures the variation in return among similar managers, that is, those within a particular asset class.  It can make sense for traditional investments where coarse risk decisions relate more to an asset class and finer risk decisions relate more to a particular manager.  Without going too much into the mathematics of calculation, we would like to offer a picture that is hopefully worth more than a thousand words. 

Below is a borrowed scatterplot of representative managers’ risk and return for various managers grouped by US Large Cap (a very famous bucket), intermediate core bonds (another very famous bucket), and alternatives.  Immediately apparent is the fact that alternative managers cover a much wider swath of that graph.  Filling the alternatives bucket with something like gold would be a different approach than filling the alternatives bucket with private equity.  This “shotgun” scatter is just that: picking a couple of alternative managers and hoping that they are somehow representative of the asset class.  One can only shudder at the difference between picking a blue manager in the upper left-hand corner of the picture versus picking a manager in the lower right-hand corner of the picture.  An investor technically would have fulfilled his/her alternatives allocation, but the reality would have been harder-hitting in one case versus the other.  Aggregation of alternatives managers makes it easier from a human perspective to deal with, but it makes it more precarious from the portfolio point of view.

In an effort to divorce the reader from any remaining notion that the bucket approach can be used without deep consideration for intrinsic nature alternative investments we present a third-party plot below.  Maybe if we further divide alternatives into sensible buckets then the dispersion might mitigate.  In the graph below we find quite the opposite.  The dispersion is tracked by taking the top of bottom quartiles of manager performance and plotting that by “asset class”.  The dispersion does not go away with finer classification.

Driving home the point Trinary Capital does believe that alternatives can add diversification to an investor’s portfolio, but putting blinders on the issue of fulfillment of the bucket might negate the benefits of alternatives.  Hopefully, this apparent and did not strike the reader as anything other than glaringly obvious.  If it did spawn some kind of epiphany, then that was the intent.

Past performance is not indicative of future results. Remember, there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investment strategies discussed in this article) will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Please remember to always speak with your individual advisor before making any investment decisions.