April 1, 2020
Fixed Income, A Better Alternative?
Liquid alternatives have not bested bonds on most key measures.
In many portfolios, the addition of fixed income has been a hedge against risks of all stripes. Even so, during an economic crisis, some investors feel the need to replace some of their fixed-income allocations with liquid alternatives in their portfolios. Proponents of these high-fee funds point to the benefits of daily liquidity for seemingly sophisticated strategies designed to provide downside protection to traditional assets (equities in particular) without reducing upside capture. Though sexier than good ol’ fixed income, has this allure of liquid alternatives delivered on those promises? Evidence spanning the last decade suggests otherwise. Fixed income has consistently trumped liquid alternatives in both offsetting equity risk and returns delivered.
Fixed Income has historically been the “safer harbor” in volatile times
U.S. fixed-income assets have typically risen during geopolitical flare-ups, recessions, and other major shocks such as a pandemic that have sent stocks reeling. For most investors, Treasuries are like a baby’s blanket—the thing you instinctively reach for whenever there’s a sense of danger.
For example, Congress raised the debt ceiling in 2011, causing the S&P® 500 index to downgrade the rating for U.S. Treasuries from AAA to AA+(1) with a negative outlook. S&P noted, rather bluntly, that the “effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.”(2) Intuitively, investors might have expected the downgraded Treasury securities to fall, yet they rallied even as stocks slumped on the same news.
As always, nervous investors made a run for the asset class they considered “safest” seemingly ignoring that, in this instance, it was also the source of negative news.
Chart 1: Treasuries rallied after S&P downgrade, while equities fell
Performance data quoted represents past performance, which does not guarantee future results.
Alternatives’ closer correlation to the S&P 500
What about the potential diversification benefits offered by liquid alternatives? Turns out, those haven’t been that great either. Over the last decade, liquid alternatives’ correlation to the S&P 500 was 0.91, while fixed income’s stood at -0.24. Liquid alternatives more closely followed equities’ lead, while bonds danced to their own beat, making them better portfolio diversifiers.
Historically, bonds offered more downside protection
Bonds appear to provide downside protection as well. Data on the performance of liquid alternatives stretches back to the great financial crisis of 2007-2008, and it doesn’t compare well to bonds. While the stock market was in a steady decline during this period, bonds were able to post positive returns to help offset the equity losses. Liquid alternatives, on the other hand, posted losses which led to further declines in portfolios. In fact, during this critical time for diversification, bonds gained 15.9% more than alternatives to help cushion portfolios from a falling stock market.
Chart 2: Performance of stocks, bonds, and alternatives during the last recession
Why alternatives don’t perform better
We believe alternatives tend to be a drag on the performance of traditional 60/40 portfolios during calm and turbulent times for two reasons: the average manager’s skill and the very nature of liquid-alternatives strategies. Many alternative strategies such as a commodity trading advisor (CTA), long-short equity, and currencies are relative value in nature, profiting by buying one security while shorting another. When volatility is low, opportunities to generate meaningful alpha are sparse due to the lack of dispersion between the stocks that are up and those that are down. Conversely, when volatility spikes, which is the case during a market crisis, investment opportunities to generate alpha expand, but the penalty for making the wrong choice is also significantly greater.
And only a relatively few managers have shown the ability to make the right trades through turbulent times—while avoiding catastrophic ones—to generate the returns investors expected. Alternative managers who gain fame for spectacular trading during one crisis are often felled by the next one since no two are alike.
The bottom line
Liquid alternatives and their “sophisticated” strategies can be alluring to the anxious investor, but they may want to consider skipping past alternatives and sticking with a long-term approach of achieving diversification through a mix of equity and fixed-income strategies. This is what has stood the test of time for investors and their portfolios.
(1)Ratings are measured on a scale that generally ranges from AAA (highest) to D (lowest).
(2)Swann, Nikola G, et al. “Research Update: United States of America Long-Term Rating Lowered To ‘AA ‘ On Political Risks and Rising Debt Burden; Outlook Negative.” RatingsDirect® on the Global Credit Portal®, Standard & Poor’s, August 5, 2011.
About Principal Risks: Asset allocation and diversification do not guarantee future results, ensure a profit or protect against loss. Although diversification among asset classes can help reduce volatility over the long term, this assumes that asset classes do not move in tandem and that positive returns in one or more asset classes will help offset negative returns in other asset classes. There is a risk that you could achieve better returns by investing in an individual fund or multiple funds representing a single asset class rather than using asset allocation.
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This commentary represents the views of the portfolio managers at Pacific Life Fund Advisors LLC as of 4/1/2020 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector, or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Sector names in this commentary are provided by the Fund’s portfolio managers and could be different if provided by a third party.
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