Introduction To Alternatives (Part 2)

This is a continuation from Part 1. In this post, I shall share with you on how to incorporate alternatives into your portfolios. 

Before thinking about how to include alternatives, let us ask ourselves one question: Should I include them in the first place? 

 

Should I Include Alternatives In My Portfolio?

 

As mentioned in Part 1, alternatives provide more diversification to have better returns and lesser risks. Among the alternatives, real estate investment trusts (REITs) and commodities are easy to understand, and could be included into your main investment portfolio. Following the Bedokian Portfolio’s make-up, REITs can make up 20% to 40% of your portfolio, while commodities would be about 5% to 10%¹. There are many types of securities and investment vehicles to invest into these two, ranging from individual shares/units of REITs, to exchange traded funds and unit trusts, to owning the actual physical thing (for gold and silver in the form of bullion).

 

For properties I had written up an earlier piece here. You may want to check it out.

 

Private equity (PE) and hedge funds, as said earlier in the previous post, are only available to sophisticated investors, so is not available directly to us retail investors, whether we want them (or like them) or not.

 

For derivatives, unless you have a sound understanding on how they work and the strategies to implement them, it is not advisable to go into them. Furthermore, derivatives are leveraged products, so your returns and risks can be amplified, too.

 

The verdict on whether cryptocurrencies (cryptos) are a financial good or an item in the greater fool theory is still out there, so if you are not comfortable going into them, then just stay out. If you are comfy with cryptos, be sure to read up on them (blockchains, DeFi, exchanges, etc.), for now they are in the realm of the Wild West.

 

If you have any collection sets or items (stamps, coins, comic books, etc.) accumulated from your hobby days, know their appraised value and in the company of like-minded people who appreciates them, you may consider monetizing your collectibles. However, do note that collectibles, unlike securities and investment vehicles, there is no common market for them, and the value would depend on the appraiser/buyer and the “flavour of the moment” (think tulips). If any returns are derived from them, it would be more of a one-off or a “few-offs”.

 

Easier Way To Go Into Some Alternatives

 

If you are not a sophisticated investor and yet want to go into PE and hedge funds, there is a way about it, and that comes in the form of exchange traded funds, or ETFs. There are at least a couple of ETFs containing listed PE firms (or you could invest in them direct by buying their shares). Most hedge fund ETFs do not really invest in the hedge fund companies themselves, but rather on the strategies employed (equity long/short, arbitrage, etc.). 

 

There are ETFs for derivatives, which I had shared on how to invest in oil using futures², plus other commodities futures. Leveraged and inversed ETFs are other examples of using derivatives. Options trading is gaining acceptance among investors and traders nowadays, and there are some options strategies available via ETFs, especially covered calls.

 

Lastly, there are also ETFs on cryptos, but most of them are centred on Bitcoin.

 

Most of the ETFs mentioned above are listed overseas, especially in the United States. You can look them up by visiting ETF-centric websites, such as www.etf.com or www.etfdb.com.

 

How To Fit Them Into My Portfolio?

 

From my point of view, PE and hedge fund ETFs should be placed as a sub-category under the equities asset class of an investment portfolio, and no more than 10% of the entire portfolio. The reasons of grouping them as equities are that PE ETFs are still made up of company shares, while a majority of hedge fund strategies involve equities one way or another.

 

Derivatives which do not belong to commodities (i.e., leveraged, inversed, options) and cryptos should be placed separately in a trading portfolio and away from the investing one, due to the holding timeframe and nature of the financial goods.

 

In conclusion, the advice of “know what you are doing” is paramount in any investment/trading decision. Going into alternatives for the sake of “jumping onto the bandwagon” is a strict no-no.

 

Stay safe, stay invested.

 

1 – The Bedokian Portfolio (2^nd Edition). P70-71.

2 – ibid. p42-43.

 

Introduction To Alternatives (Part 1)

After swimming around comfortably in the pool of investing, you might have come across this term “alternatives” while doing your laps. Alternatives, or alternative investments in full, are assets that do not belong to the common mainstream asset classes/financial instruments, namely equities (shares/stocks), bonds and cash.

There are several alternatives; some are asset classes, investment vehicles, methodologies, or a combination of the former two/three. Examples include real properties, hedge funds, private equities, cryptocurrencies, derivatives, etc. The Bedokian Portfolio already contains two alternatives, namely real estate investment trusts (REITs), an equities-property hybrid, and commodities (gold, silver and oil).

 

Alternatives are usually included due to their different correlations with equities and bonds, thus providing more diversification and hence, better returns with lesser risks in an investment portfolio.

 

Writing about alternatives would warrant an entire book, or a series of books, depending on how much details are written. I would give a very short summary of the various alternatives available out there. I had covered commodities and REITs in the eBook¹, so I would not state them here.

 

Property

Property is referred to as immovable property, for example land, houses, apartments, buildings, factories, warehouses, etc. They are generally used to earn rental income, and there is a huge potential in capital gain when its value increases, especially when the property is in a prime location, and/or in an increasing economic growth environment. Properties are leveraged items; unless one is rich enough to pay it off in one shot, a loan is needed to be taken out to fund the purchase. Therefore, for a property investor, a typical strategy would be using the rental income to cover the mortgage payments, with either divesting in the future to realise capital gains, or for keeps for legacy reasons.

 

Private Equity

Private equity, or PE for short, is an investment in a company that is not publicly traded in the financial markets. There are two main approaches of PE: venture capital (VC) and leveraged buyouts (LBOs). Some of you may have heard of VC, where a VC firm would put a stake in start-ups or small companies with huge potentials, and either sell them to larger companies or list them publicly a few years down the road. A lot of well-known companies that are listed in the markets currently were funded initially through VC, such as Alibaba, Google, etc. 

 

For LBO, a PE firm would buyout a private company using debt or leverage (thus the term), and just like VC, the acquired company would eventually be sold or listed a few years later. Whether VC or LBO, the common thing between the two is that the PE firm would have some say in the management of the funded/acquired companies, ranging from advisory to direct control. 

 

PE is in the domain of sophisticated (accredited and institutional in investment talk) investors, who are usually high net worth individuals, funds, investment firms, etc.

 

Hedge Funds

Hedge funds are funds that use different strategies to earn returns for the investors who have a stake in it. Though hedge funds buy and sell shares most of the time, which may seem on the surface that they are no different from equities, it is the strategy(ies) employed that make them stand out. 

 

Some of the selected hedge fund strategies include:

 

Equity Long/Short: Purchasing of a company’s (or some companies’) shares while at the same time short-selling others’, usually across sectors or industries.

 

Market-Neutral: Similar to equity long/short, but the approach involves both longing and shorting within the same sector/industry. It is “neutral” in a sense as this strategy is not concerned on where the markets are heading, but rather exploiting the relative performances of the companies within the sector/industry.

 

Dedicated Short Bias: As it goes, shorting is the name of the game, although a few hedge funds adopt a net short method (i.e., short positions more than long positions).

 

Global Macro: A strategy which makes use of the geo-political and socio-economical situations around the world. Investments are not just limited to equities, but also other asset classes.

 

Arbitrage: Arbitraging is an art or skill of identifying mispricing of the same security across two or more markets, and make a profit from it. Here is a layman example: at a given time, if an item is selling at S$1 and S$1.50 at locations A and B respectively, I would buy it at location A and sell it at location B.

 

Event Driven: This approach utilises happenings in the corporate world and takes advantage of the expected mispricings, such as mergers, acquisitions, spin-offs, etc. 

 

Multi-Strategy: As described, it means a hedge fund could employ two or more of the strategies mentioned above.

 

Just like PE, hedge funds are in the domain of sophisticated investors.

 

Cryptocurrencies

A relatively new asset that emerged from the shadows of the Global Financial Crisis of 2008/2009, cryptocurrencies (or cryptos for short) are gaining widespread popularity and traction in recent years. The great ancestor of cryptos is none other than Bitcoin, which is also famous for the accompanying blockchain technology. Though they are touted as a form of digital currency for the future, as of now they are mostly used for speculative trading.

 

Collectibles

Collectibles are items that are likely to worth more the longer they are kept, and some examples include artwork, antiques, rare coins, stamps, wine, etc. On the crypto front, there are also non-fungible tokens (NFTs). The difficulty of having collectibles as an investment is the appraisal and valuation of their current and potential worth, unless you hire an expert to look into them or you are an expert yourself.

 

Derivatives

Derivatives are a category of investment vehicles that derive (the root word) their value from an underlying asset. In other words, you do not really own the asset using derivatives, but rather they sort of mimic the asset class itself by following the value. 

 

Derivatives are used more for trading than investing, and most derivatives lose their value over a certain time, such as within the next few days, weeks or months. Examples of derivatives include futures, options, warrants, swaps, contracts-for-differences (CFDs), etc. There are also stacked derivatives, like options on futures and options on swaps.

 

In Part 2, I shall share further on how to incorporate alternatives into your portfolios.

1 – The Bedokian Portfolio (2^nd Ed). Chapter 5 Commodities; Chapter 6 REITs p45-50.

Does Rebalancing Frequency Affect Returns?

Rebalancing is the act of bringing one’s investment portfolio to its “original” state of predetermined asset class allocation levels, and it is one of the core tenets of diversification. Typically for passive investors, rebalancing is done once or twice a year; this frequency is seen as balancing between maintaining the portfolio and the transaction costs that come along with rebalancing.

With the advent of brokerages offering less expensive commission charges and fees, the costs of rebalancing monthly or quarterly may be equal or below to that of semi-annual or annual rebalancing using brokerages that still charge commissions at prices a decade ago. This is highly plausible if a passive investor only has 5 or less securities (especially exchange traded funds, or ETFs) in his/her portfolio.

 

On this thought, I decided to carry out a little test to see if the rebalancing frequency affects returns. Using the data from Portfolio Visualizer¹ (www.portfoliovisualizer.com), I used three portfolios: the traditional 60/40 equities/bond, the Bogleheads Three-Fund (50% United States (US) equities, 30% global ex-US equities and 20% bonds) and the balanced Bedokian Portfolio (35% equities, 35% REITs, 20% bonds, 5% commodities using gold and 5% cash).

 

Three rebalancing scenarios are used: monthly, quarterly and annually. The initial amount would be US dollars (US$) 12,000, and subsequent injection would be US$ 1,000 per month for monthly, US$ 3,000 per quarter for quarterly and US$ 12,000 per year for annually. The period tested would be from January 1994 to December 2021 (this period is used as the earliest REIT data obtained is from January 1994).

 

Period Jan 94 - Dec 21	Portfolio Returns (US$)
Rebalancing Frequency	60/40 Equities/Bond	Bogleheads Three Funds	The Bedokian Portfolio
Monthly	1,420,865	1,686,410	1,999,423
Quarterly	1,444,998	1,707,376	2,014,024
Annually	1,402,952	1,661,966	1,934,630

Fig. 1: Portfolio returns with monthly, quarterly and annual rebalancing, Jan 1994 to Dec 2021. Figures are before inflation.

 

Interestingly, returns using quarterly rebalancing came out tops, with monthly rebalancing coming in second and annual rebalancing third.

 

Let us look at another set of results, the average 10-year and 15-year rolling returns. These two timeframes are used on the assumption that an investment portfolio is maintained for at least 10 years.

 

Period Jan 94 - Dec 21	Portfolio
Average Rolling Returns (Rebelancing Frequency)	60/40 Equities/Bond	Bogleheads Three Funds	The Bedokian Portfolio
10 Years (Monthly)	6.47%	6.78%	8.48%
15 Years (Monthly)	6.26%	6.44%	8.08%
10 Years (Quarterly)	6.59%	6.88%	8.55%
15 Years (Quarterly)	6.38%	6.54%	8.16%
10 Years (Annually)	6.63%	6.96%	8.51%
15 Years (Annually)	6.44%	6.63%	8.10%

Fig. 2: Average 10-year and 15-year rolling returns with monthly, quarterly and annual rebalancing, Jan 1994 to Dec 2021.

 

Surprisingly, the results were mixed. Annual rebalancing brings about a higher average rolling returns for the 60/40 equities/bond and Bogleheads Three-Fund for 10-year and 15-year, while the Bedokian Portfolio’s quarterly average rolling returns were better than the other two variations.

 

Do note that the data used is based on the perspective of the US markets, and transaction costs and taxes are not factored in.

 

Explanation And Conclusion

 

From a prima facie observation, the dataset used for the asset classes were the same throughout the three portfolios, hence there is a probability that the individual asset class(es) themselves are displaying better returns by quarterly capital injection. There is also the possibility that for quarterly rebalancing, the securities were bought in at lower price points as compared to monthly or annually, where the latter two could be bought in at higher price points. 

 

As for the average rolling returns, since it is an average reading, the actual numbers that form the average may see more deviations around the mean, which may explain why the annual average 10-year and 15-year rolling returns were higher even with quarterly rebalancing bringing in more returns (for the 60/40’s and Bogleheads’).

 

While looking through the figures of different timeframes (at least 10 years) of different portfolios using Portfolio Visualizer (which I had not published here), it seems that returns from quarterly rebalancing were relatively better than those from monthly and annual ones. Perhaps going quarterly is better? 

 

Then again, we cannot have this conclusion due to two simple reasons: first, I had only utilized one data source. The dataset used is based on the presumptions that Portfolio Visualizer had stated, such as the sources and method of calculations. It is recommended that other sources (and their underlying basis of data) are to be used so that we could have a fair comparison across. 

 

Second, and more importantly, all these are inferences and results from past data, and we all know that past performances are not indicative of future results.

 

Stay safe and stay vested.

 

1 – https://www.portfoliovisualizer.com/backtest-asset-class-allocation