Goldman Sachs strategists say investors hold too much stocks and bonds and need to jack up alternatives allocations

It's a matter of diversifying rather than dabbling: Adding a few percentage points 'is not doing anything'

Oct 7, 2014 @ 9:21 am

By Jeff Benjamin

In the 1970s it made sense for investors to invest almost solely in stocks for risk and bonds for safety. But those days are long gone, according to Theodore Enders, senior portfolio strategist at Goldman Sachs Asset Management.

“It's typical and even understandable to think about an investor's risk tolerance based on stock and bond allocations, but that's how they did things back in the 1970s, when things were a lot different than they are today,” Mr. Enders said Monday during a presentation on alternative investments at the Investment Management Consultants Association conference in San Diego.

Referencing the bygone days of fixed-income investing, when the market was largely made up of high-quality corporate bonds, Mr. Enders said that “investors still hear the word bonds and think of safety.”

“These days, you own things in your portfolio for some type of return, and that includes alternatives,” he added.

Mr. Enders was joined in the presentation by Bruce Emken, a member of the Goldman Sachs alternatives sales team, to drive the case for adding alternatives to investor portfolios.

The suggestion was not just to dip a toe in the water, but to dive in with allocations of between 19% and 24% in order to make a real difference on long-term performance and reduced volatility.

“Think of it as dabbling versus diversifying,” Mr. Emken said. “Adding a few percentage points of alternatives just to check a box is not doing anything.”

The duo acknowledged the explosive popularity of the liquid alternatives space, including a growing list of registered mutual funds that employ popular hedging strategies such as long-short, macro, event driven, and relative value.

With liquidity being a requirement in the mutual fund format, private equity and private real estate are two alternative strategies not expected to enter the liquid alternatives space anytime soon.

“Most investors own way too much equity and bond risk,” said Mr. Enders, who presented portfolio models that reduce risk by adding alternatives.

Looking at a traditional core portfolio of 70% stocks and 30% bonds, for example, he showed how to manage risk with the addition of both alternative strategies and what he called strategic satellites. This includes long-only asset classes that tend to have high risk premiums and lower correlation to the core asset classes.

Examples of the strategic satellites are emerging-market stocks, international small cap stocks, public real estate, commodities, leveraged loans, and global high-yield bonds.

In the example presented, core equity exposure falls to just 22% of the portfolio, while core fixed income stays at 30%. The rest of the portfolio is made up of 29% strategic satellite exposure and 19% alternative investments.

The result, Mr. Enders explained, is a dramatically reduced and more diversified risk profile.

In the traditional 70-30, stock-bond portfolio, stocks represent 99% of the portfolio's 12% expected annual volatility.

In the more diversified model, the risk was divided as follows: 40% from equity, 45% from strategic satellites, 12% from alternatives, and 3% from bonds. The key point is that in the more diversified portfolio, the expected annual volatility drops down to 8.8%.

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