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Alternative Investments: History of Performance and Their Risk-Return Frontier By Paul Hoffmeister and Thomas F. Kirchner, CFA

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Page 1: Alternative Investments: History of Performance and … · Alternative Investments: History of Performance and Their Risk-Return Frontier By Paul Hoffmeister and Thomas F. Kirchner,

Alternative Investments:History of Performance and Their Risk-Return Frontier

By Paul Hoffmeister and Thomas F. Kirchner, CFA

Page 2: Alternative Investments: History of Performance and … · Alternative Investments: History of Performance and Their Risk-Return Frontier By Paul Hoffmeister and Thomas F. Kirchner,

1 | QUAKER FUNDS

Investors are rushing into liquid alternative investments more than any other fund category. According to Morningstar, alternative funds have grown from approximately $62 billion in assets at the end of 2008 to $179 billion as of the end of 2013.1 This explosive growth mirrors that of hedge funds a decade earlier.

The rush is understandable. The 2008-2009 financial crisis starkly reminded investors of the significant loss potential of equity investments, and the Federal Reserve’s expected departure from its unprecedented policy easing is raising concerns about risks to fixed income investments. As a result, investors are naturally looking to diversify their portfolios away from the risks inherent in the two traditional asset classes.

Arguably, the risks and uncertainties associated with stocks and bonds are why institutional investors, who are highly focused on attractive risk-adjusted returns, have been making alternatives an essential component of their diversified portfolios for decades.

When it comes to deciding how to add alternatives to a diversified portfolio mix, it’s important to know what you’re getting. An important maxim to remember is: all alternatives are not created equal. Saying that one is invested in alternatives is akin to saying, for instance, that one is invested in mutual funds. Both statements are simply too ambiguous for the thoughtful investor.

To provide a useful starting point in evaluating how to add alternatives to one’s portfolio, we distinguish in the following between some of the most common alternative investments, examine the performance of each since 1990, and then incorporate them into a traditional 60/40 allocation.

Historical Performance of PoPular alternatives

Alternative investments can be defined as any asset classes other than stocks, bonds or cash. This catch-all definition includes commodities, real estate, and even art, wine, coins and stamps.

Another, more specific definition for an alternative is an unconventional strategy for investing in stocks and bonds that creates return streams and risk profiles meaningfully different from traditional equity and fixed income investments.2 The differing return streams and risk profiles are why some hedge fund investors have been using these strategies for decades. Some of the popular alternative strategies include merger arbitrage, convertible arbitrage, market neutral, equity long/short, event-driven, distressed investing and managed futures. This popularity has led to these alternative strategies becoming increasingly available to mutual fund investors.

The data illustrated in Figure 13 shows the risk (represented by standard deviation) and return performance since 1990 of these popular alternative strategies:

Since 1990, the average annual return of these seven alternatives was 10.39% with a standard deviation of 6.70%. Not only did this group of alternative strategies annually outperform the S&P 500 by 94 basis points, it did so with approximately 55% less risk (as measured by standard deviation). These attractive risk-adjusted returns are what some sophisticated investors are seeking.

One way to assess risk-adjusted returns is through the Sharpe Ratio, which measures the performance of a portfolio by adjusting for its risk. Essentially, the Sharpe Ratio indicates how much reward an investor receives for each unit of risk. Therefore, the higher the Sharpe Ratio, the better the portfolio’s risk-adjusted performance has been.

Arguably, the risks and uncertainties associated with stocks and bonds are why institutional investors, who are

highly focused on attractive risk-adjusted returns, have been making alternatives

an essential component of their diversified portfolios for decades.

© 2014 Quaker investment trust

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FIGURE 1:RISK-RETURN GRAPH (01/1990 - 12/2013)

FIGURE 24:SHARPE RATIO COMPARISON (01/1990 - 12/2013)

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Asset classes represented by the same indexes shown in Figure 1.

Page 3: Alternative Investments: History of Performance and … · Alternative Investments: History of Performance and Their Risk-Return Frontier By Paul Hoffmeister and Thomas F. Kirchner,

AlTERNATIvE INvESTMENTS: HISTORy OF PERFORMANCE AND THEIR RISK-RETURN FRONTIER | 2

Not surprisingly, the average Sharpe Ratio of 1.09 for these seven alternatives is meaningfully higher than the 0.41 for the S&P 500. It is also higher than the 0.87 Sharpe Ratio for the Barclays Aggregate Bond Index.

tHe “alternative risk-return frontier”

This scattergram (Figure 35) of the returns and standard deviations of alternatives illustrates how these popular investment strategies generate highly attractive returns with attractive risk. We call this: the “Alternative Risk-Return Frontier”. And it is our belief that investors are looking to alternatives to achieve investment performance that lies specifically on this frontier.

incorPorating alternatives into a traditional 60/40 Portfolio

So how can an individual think about adding alternatives into their portfolio? Nadia Papagiannis, formerly the director of alternative fund research at Morningstar Inc., has stated that an allocation to alternatives should begin with at least a 5% allocation, although in order to have any kind of real impact, that allocation should grow to at least 20%.6 Some university endowments are reported to have allocations as much as 40%.7

The table shown in Figure 4 portrays a traditional retail portfolio built upon a 60/40 allocation. Between January 1990 and December 2013, this hypothetical portfolio of 60% stocks and 40% bonds would have generated an annualized 8.74% return with a standard deviation (representing volatility) of 9.07% (when rebalanced annually).

Based on the historical data, by adding a 20% allocation comprised of the seven previously mentioned alternatives (equally weighted) and equally reducing the portion devoted to stocks and bonds, the hypothetical investor increased his or her annualized return to 9.22% and reduced standard deviation to 8.12%.

There may even be a simpler, more convenient solution than a basic 20% allocation to the seven alternatives: allocating to one alternative whose performance during the long-term approximately resembles that of the aggregated seven.

While not exactly alike, the risk-return profile of a 50-30-20 portfolio using only event-driven as the alternative investment since 1990 produced returns and created risks similar to one utilizing all seven popular alternative strategies as their 20% allocation.

Specifically, the 50-30-20 allocation between stocks, bonds and alternatives where the allotment to alternatives is only to event-driven, produced a 9.41% annual return with 8.50% standard deviation. This compares to an annual return of 9.22% and standard deviation of 8.12% for the 20% allocation comprising each of the seven alternatives.

Why did event-driven produce returns and risks since 1990 as an allocation similar to some of the most popular alternatives? The answer may lie in the fact that the event-driven strategy has historically been a multi-strategy investment vehicle incorporating other alternative strategies, such as merger arbitrage and distressed investing. As a result, the multi-strategic nature of event-driven may be one important factor in enabling it to perform within the heart of the coveted Alternative Risk-Return Frontier.

all rights reserved. may not be reproduced or redistributed in whole or in part.

FIGURE 48:risk/return taBle

January 1990 - december 2013: annualized summary statistics

Return Standard Deviation

Barclays U.S. Aggregate 6.56% 3.72%

S&P 500 9.37% 14.88%

60/40 Equities/Bonds (“Traditional” Portfolio) 8.74% 9.07%

50/30/20 Equities/Bonds/7 Popular Alts* 9.22% 8.12%

50/30/20 Equities/Bonds/Event-Driven* 9.41% 8.50%

*Rebalanced AnnuallyFIGURE 3:RISK-RETURN SCATTERGRAM (01/1990 - 12/2013)

Less Risk More Risk

0% 4% 8% 12% 16%2% 6% 10% 14%

Standard Deviation

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MARKETNEUTRAL FIXED INCOME

LONG/SHORT

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EVENT-DRIVENDISTRESSED

MERGER ARB

MANAGED FUTURES

EQUITIES

THE ALTERNATIVE RISK-RETURN FRONTIER

Asset classes represented by the same indices shown in Figure 1.

FIGURE 59:RISK-RETURN SCATTERGRAM (BlENDED PORTFOlIOS 01/1990 - 12/2013)

Less Risk More Risk

0% 4% 8% 12% 16%2% 6% 10% 14%

Standard Deviation

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TRADITIONAL PORTFOLIO60% EQUITIES40% FIXED INCOME

50% EQUITIES30% FIXED INCOME20% EVENT-DRIVEN

50% EQUITIES30% FIXED INCOME

20% IN THE 7 POPULAR ALTS

Asset classes represented by the same indices shown in Figure 1.

Asset classes represented by the same indices shown in Figure 1.

Page 4: Alternative Investments: History of Performance and … · Alternative Investments: History of Performance and Their Risk-Return Frontier By Paul Hoffmeister and Thomas F. Kirchner,

endnotes

1-2 How Alternative Are Alternative Funds by Adam Zoll, Morningstar, January 15, 2014.

3 Risk-Return Table (January 1990 - December 2013: Annualized Summary Statistics). Source: Zephyr StyleADvISOR®.

4 Sharpe Ratio Comparison (January 1990 - December 2013: Annualized Summary Statistics). Source: Zephyr StyleADvISOR®.

5 Risk-Return Scattergram (January 1990 - December 2013: Manager Risk/Return Single Computation). Source: Zephyr StyleADvISOR®.

6 InvestmentNews.com, “Allocate Enough in Alts to Make a Difference,” by Bruce Kelly and Jason Kephart, September 23, 2013.

7 National Association of College and University Business Officers.

8 Risk-Return Table (January 1990 - December 2013: Annualized Summary Statistics). Source: Zephyr StyleADvISOR®.

9 Risk-Return Scattergram Blended Portfolios (January 1990 - December 2013: Manager Risk/Return Single Computation). Source: Zephyr StyleADvISOR®.

Past performance does not guarantee future results.

Alternative Investments are speculative and involve substantial risks. Alternative investments may result in additional risk due to their complexity and possible illiquidity and require specialized investment expertise. Investments in smaller companies involve additional risk such as limited liquidity and greater volatility than larger companies. Investors may lose some or all of their investment.

Direct investment in an index is not possible and securities in a Fund will not match those in an index.

There is no assurance that a portfolio will achieve its investment objective. In addition, there is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline. Accordingly, you can lose money investing in this strategy. Please be aware this strategy may be subject to certain additional risks, which should be considered carefully along with the strategy’s investment objectives and fees before investing.

standard deviation is a portfolio risk statistic used to measure variability of total return around an average, over a specified period of time.

mutual fund investing involves risk, including the possible loss of principal.

Consider a fund’s investment objectives, risks, charges, and expenses carefully before investing. The Statutory, and where available, the Summary Prospectuses contain this and other important information and are available for download at www.quakerfunds.com or by calling 800.220.8888. Read carefully before investing.

©2014 Quaker® Investment Trust | The Quaker® Funds are distributed by Foreside Fund Services, llC. QKANE 022014

Contact us:Quaker® Funds, Inc. c/o U.S. Bancorp Fund Services, llC | P.O. Box 701, Milwaukee, WI 53201-0701800.220.8888 | www.quakerfunds.com