EC These Alt ETPs Are Proven Diversifiers

We’re often told that there’s no free lunch in investing, that there’s a price to be paid for every benefit. There seems to be a carve-out, however, for diversification. Advisors often tell their clients that, done properly, diversifying a portfolio’s risk can tamp down volatility without reducing expected returns.

There’s been no greater source of diversification than alternative investments, or “alts”. Defined broadly, these are exposures that promise little or no correlation to portfolio mainstays such as equities and, perhaps, conventional fixed-income securities. Hedge funds were once the only avenue through which investors could access alts, but that’s no longer the case. Numerous exchange-traded portfolios (ETPs) now wade in the alternative waters. 

It’s no secret that these strategies have been pretty much a bust, while equities were screaming to the upside over the past few years. But now that the wheels on the stock market bus are starting to wobble, alts are getting a renewed look.

So, which alt ETP is likely to provide the greatest degree of diversification?

To answer that question, we have to first look to the past. We started by surveying the field to find funds with track records. Aiming for ETPs with two-year histories, we filtered out volatility-index-tracking funds as being purely tactical, rather than long-term, holdings. With that, nearly three dozen alternative ETPs came into view.

Next, we had to come up with a measure of diversification. For that, we reasoned that a well-diversified portfolio is one that exhibits less overall risk than the summed weighted risks of its components. A ratio, therefore, greater than one (1.00), with the portfolio components’ aggregated risks in the numerator and the portfolio’s overall risk in the denominator, demonstrates a diversification benefit.

A simple benchmark portfolio illustrates how the diversification effect is measured. A classic 60/40 mix can be constructed by allocating 60 percent of our hypothetical capital to the SPDR S&P 500 ETF (NYSE Arca: SPY) and 40 percent to the iShares Core U.S. Aggregate Bond ETF (NYSE Arca: AGG). The standard deviation of the SPY portfolio’s returns over the past two years is 9.19 percent; that of AGG is 2.80 percent. The weighted sum of these two components’ volatilities is 6.62 percent, but when combined, they produce a portfolio with a standard deviation of just 5.79 percent. The result? A 1.14 diversification ratio.

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Disclosure: None.

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