A new study carried out by Dexia Asset Management shows the benefits of allocating 15% to 20% of a portfolio to alternative funds.
Finding a good balance between risk and return is the first aim of any investment strategy. Modern portfolio management theory suggests diversification, so as to cope with the volatility of the market and to reduce the risk in a portfolio. So it is recommended that a portfolio be diversified in terms of asset classes (equities, bonds), geographic regions and sectors. Even so, it has been proved that even though a traditional portfolio of equities and bonds is well diversified at international and sector level, this will not be enough to resist a generalised market decline.
Among the new approaches – enabling investors to improve the diversification of their portfolio and to limit its downside risk – are alternative investments, the performance of which is not correlated to that of the financial markets. These days markets are more and more volatile, and investors are seeking investments which react in a different manner to traditional investments in equities or bonds. Adding alternative products to a traditional diversified portfolio, as a non-correlated class of assets, may therefore create significant added value.

Alternative investments
Although the existence of the first alternative funds goes back some 50 years, it was at the beginning of the 1990s that the alternative industry really took off, with the aim of countering the heavy losses recorded on the stock markets.
Alternative management seeks to generate positive performance, whether the evolution of the traditional markets is upwards or downwards. It achieves its profitability from relative variations between different assets independently of the market’s direction. It resorts to various management techniques, based on multiple supports (leverage techniques, arbitrage, long/short positions and so on). Among the different strategies, the method is identical, since it exploits market inefficiencies so as to produce performance. According to the type of strategy, alternative assets offer very different risk-return profiles.
Alternative management seeks to obtain an evolution which is not correlated to the bond or equity markets, and therefore has an ability to preserve capital during phases of decline. It is focused on maximising the risk-return ratio (in the long term alternative funds present one of the best risk-return ratios on the market).
Alternative products are often described as assets endowed with absolute profitability, precisely because they are not related to any market index, in contrast to the majority of funds. The objective is to seek absolute performances (7%, 10%, or 15% for example) or to outperform money markets.

Summary of various alternative strategies:
n Relative value: take profit from the spread between a current quotation and a theoretical value, after hedging away equity, interest rates and currency risks of underlying markets
n Event-driven management: profit by capturing the spread between a current quotation and an offered quotation on a security in special situations (mergers, acquisitions, take-overs, bankruptcies and so on)
n Trend following: exploit investment opportunities on mid and long term detected trends, either bullish or bearish, over a large range of futures markets
n Opportunistic: exploit investment opportunities between current prices and expected prices, over a large range of financial markets or on specific markets, through discretionary or quantitative processes

Advantages of alternative investments in a diversified portfolio
In view of the characteristics referred to above, alternative assets are a diversification tool par excellence for introduction into a portfolio. In fact:
– alternative investments enable access to specific asset classes.
– The very low correlation between the various alternative indices and the traditional equity and bond indices demonstrates the opportunity to improve the risk-return profiles of portfolios as a whole and therefore to improve diversification.
– They enable limitation of the absolute downside risk of the portfolio in case of severe volatility (even though, in a period of extreme market movements, some asset classes may show a higher correlation).
Mean-variance optimisation is the traditional method used to demonstrate the benefits of diversification, and a good number of studies have already used it to demonstrate the benefits of diversification in alternative funds. The objective of mean-variance optimisation is to build the portfolio with the best risk-return characteristics.
At Dexia Asset Management we wanted to confirm such results and to determine how to introduce alternative funds into a diversified portfolio so as to obtain the optimum risk-return profile. This analysis was carried out in-house via different methodological approaches: classical mean-variance optimisation, Bayesian mean-variance optimisation, statistical mean-variance optimisation, VAR, maximum drawdown etc.
The volatility and correlation data used in this analysis are historical data, while the returns of indices or funds observed are either historical returns or expected returns, according to the method used.
The results of the classical mean variance show that the best risk-return profile is obtained by constructing a portfolio with an allocation to alternative funds of at least 30% (minimisation of variance), and more often 50% (maximisation of the Sharpe ratio). The best results are observed when the allocation to alternative funds combines different types of strategies (relative value and directional).
The results obtained with Bayesian and statistical mean-variance are rather similar to traditional mean variance, and the other alternative risk measures such as VAR, tail-VAR, semi-variance and maximum drawdown show results comparable to those obtained within a context based on mean-variance: Introducing alternative funds to a diversified portfolio improves its risk-return profile and provides efficient diversification. The results of our analysis are shown in the table.
The results are relatively variable according to each approach, but clearly show that the introduction of alternative funds is always justified within a diversified portfolio. It can be observed that, when measures are based on historical returns, the best results are obtained when the allocation to alternative funds is funded exclusively out of equities, whereas when it is based on expected returns, the allocation funded out of the two types of assets, equities and bonds proportionally, is preferred.
Because of the high uncertainty on expected returns of alternative funds, it seems preferable to limit the allocation to a maximum 15–20% of the portfolio.
An analysis of historical two-year returns, since 1995, of several portfolios composed of variable proportions of equities, bonds and alternative funds (10% or 20% in alternative funds) also confirmed that the alternative assets presence in a portfolio significantly improves the risk profile, and shows on the other hand that minimum historical performance is much higher (lower downside risk). However the historical maximum relative drawdown is probably too high with 20% allocated in alternative funds. It appears much more acceptable with a 10% allocation.
In view of these results, we conclude that the proportion of the portfolio to be allocated to alternative funds should be limited to 15%-20% of the portfolio. It seems preferable to us to introduce them in two steps. First of all, 10% will be introduced equally out of bonds and equities. If equity markets progress significantly over the next 12 to 24 months, the funds will then be increased to 15% then 20% out of the equity part. The alternative assets part should be formed of a combination of alternative funds or funds of funds, and will include a large diversification of alternative strategies, tending approximately to 50% of relative value strategies and 50% of directional strategies. The VAR of alternative assets should be regularly monitored.
This document briefly summarises the results of a study carried out by Dexia Asset Management. For more information on those studies, please contact investor.support@dexia-am.com

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