The past decade has been a daunting time for stock market investors, but judicious use of alternatives could have brightened clients’ spirits.

From 2002 through 2011, a hypothetical 20% portfolio shift, from the S&P 500 to a mix of alternatives, would have increased the annualized return by nearly 33% while decreasing the annualized standard deviation, according to a white paper, “Bringing The Benefits Of Alternative Investments to Client Portfolios,” co-authored by Steve Medina, co-head of global asset allocation at John Hancock Asset Management, and Michael Stephens, senior product manager at John Hancock Financial Services.

The white paper groups alternatives into three broad categories:

  • Alternative markets, such as commodities and global real estate;
  • Alternative investment approaches, such as tactical and multi-sector techniques; and
  • Absolute return strategies, where managers take long and short positions to net out their exposure to market.

“Alternatives are a very broad and heterogeneous area,” Medina told Financial Planning. “If you drill down farther into our ‘three bucket’ categorization scheme, you'll probably find as many differences in return and volatility profiles as you would similarities within each bucket.

“That said,” Medina continued, “intuition suggests that the absolute return area is probably the place where you are likely to find the strategies that provide the most effective improvement in risk/reward profiles. These strategies tend to have much lower correlations and tend to have lower risk profiles than either alternative markets or alternative investment approaches.”

Furthermore, some strategies in the absolute return area also bring the promise of equity-like returns over a full market cycle. “The absolute return space also carries the caveat that the manager may not be able to deliver the expected risk/volatility profile,” Medina warned, “and the strategy may not translate well from a hedge fund-type structure to a mutual fund product.” As the white paper notes, mutual fund companies have created many alternative investment vehicles for advisors and retail investors.

The white paper compares a 10-year investment in the S&P 500, through 2011, with an investment that’s 80% in that index and 20% in a hypothetical alternatives portfolio that contains indexes of commodities, emerging-market debt, real estate investment trusts, market neutral funds, global macro funds, and merger arbitrage funds.

With these alternatives in equal weights, the annualized return would have jumped from 2.92% to 3.88%; the annualized standard deviation would have dipped from 15.86 to 13.97. In essence, this hypothetical 80-20 portfolio would have captured nearly 91% of results during up markets but only about 85% of down market disappointment. Responding to a query from Financial Planning, Medina indicated that going from 20% to 25% or 30%, with this hypothetical mix of alternatives, would have continued to increase return and reduce standard deviation, during this time period.

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