Pinnacle clients will soon be noticing that their statements have a slightly different look. Instead of all of the alternative investments in the portfolio being reported together at the end of the holdings reports, we now split them up into equity alternatives and fixed income alternatives. When asked I usually define alternative investments as those asset classes or investment strategies that have a low correlation to both stocks and bonds. However, it is helpful to further differentiate among the alternatives to get a better understanding of what they mean to us in terms of our portfolio construction.
I divide alternative investments into three general categories. First are asset classes that historically have low correlations to stocks and bonds. The best example of this in our current portfolio is gold (GLD) and long-only commodity future indexes (UCI). These exchange traded funds and notes are not actively managed and their correlation to stocks and bonds is entirely dependent on the performance of the underlying asset class. The second group of alternatives falls into a group I call “alternative strategies.” The Merger Fund and TFS Market Neutral fund are examples of this group in current Pinnacle portfolios. While the funds are very actively managed, the underlying strategy is designed to consistently deliver low correlations to stocks and bonds. While the managers can get “hot” or “cold,” unless something horrifying occurs correlations should stay low. The final group falls into what I call “managed alternatives” and would include Leuthold Core Fund and the Hussman Strategic Growth Fund. In this group equity managers have the freedom to take the portfolio relatively long or relatively short (in Hussman’s case he can take the portfolio to 0% net equity) so the correlation of these funds to the broad market will vary greatly depending on how the managers position the fund.
Of the three types of alternatives, it is the last group that presents the most problems for us as portfolio managers. We know that over time the correlation of these funds can change and when they do we have to decide if we need to adjust our overall risk allocation to reflect the change. Neither fund has consistently beaten its benchmark during the current bull market. Hussman has been generally bearish and Leuthold has had issues with security selection. Both of these managers are brilliant but I’m guessing that we will be reducing our holdings in both funds in some, but not all, of our strategies as we enter the New Year.