Over the long run, alternative investments have outpaced traditional 60/40 stock/bond portfolios with lower volatility. What’s the secret? Gaining more in up markets than they lose in down markets.
The Upside/Downside Capture Ratio
Successful alternative strategies are managed to capture some part of the equity market’s upside and an even smaller part of the market’s downside. The concept is to win by not losing, and it’s reflected in the up/down capture ratio.
Let’s take a strategy with an up/down capture ratio of 50/20. When markets are doing well, it delivers 50% of the upside; when markets are down, it delivers 20% of the downside. Capturing only half of the equity market’s gains in an up market with an alternative strategy may not sound too appealing on the surface. But what’s the flip side? In bear markets, investors experience only 20% of the downside.
Alternatives vs. Equity: The Tortoise and the Hare
Let’s compare a hypothetical $10,000 investment made in 1995—for 20 years—in the S&P 500 equity index with an equal investment in a hypothetical alternative strategy with a 50/20 up/down capture ratio (Display).
It ends up looking a lot like the fable of the tortoise and the hare. The S&P 500—the “hare” in this scenario—got off to a fast start. During the tech bubble buildup in the late 1990s and early 2000s, the equity market dominated—and the gap between the two investment approaches widened.
But then the tech bubble burst, and the S&P 500 lost major ground. The 50/20 alternative strategy—the “tortoise”—which had been steadily, if modestly, plugging along at “half-speed” until the sell-off, pulled ahead. As we know, markets eventually stabilized and US equities resumed their upward march. But just as the S&P 500 started to catch back up, the 2008 financial crisis sent stocks reeling again. The S&P 500 lost 51% of its value by early 2009, while the 50/20 declined by only 10%. The importance of that is found in the time needed to recover the losses. In the recovery that followed, the 50/20 was back to its previous peak in nine months. The S&P 500 took more than three years. Indeed, despite very strong US equity market performance over the past several years, the S&P 500 has still not caught up.
Over a 20-year span of this tortoise and hare battle, the alternative strategy would have ended up delivering dramatically higher returns than the S&P 500—but with less than half of the stock market’s volatility. Pretty crafty turtle.
The Insurance Perspective
Why doesn’t everyone find an alternative strategy with 50/20 up/down capture? After all, this isn’t just hypothetical—the average up/down capture ratio of the entire HFRI Equity Hedge category, for example, is 65/32. In large part, it likely has to do with the investment experience. In other words, some investors would rather simply fire a manager who delivered just 50% of the market’s upside in a rally.
When that frustration sets in, it’s easier to dismiss a strategy’s effectiveness in bear markets. This was magnified in the past few years by a central bank–supported “beta trade,” with strong performance and generally short-lived downturns. That appears to be changing, but investors need to be diligent in searching for a strategy that fits their long-term needs.
It helps to think of a strategy’s up/down capture ratio as an insurance policy. For the strategy with 50/20 up/down capture, the difference between the market’s gain and the strategy’s up capture—in this case, 50% of the full market gain—is the insurance premium you pay in terms of sacrificed upside potential during up markets. The “down” capture of 20% can be viewed as a deductible—you experience a loss of 20% on the alternative strategy before its “policy” kicks in and protects the downside.
Finding the Right Fit
Alternative strategies come with many different combinations of upside and downside market capture. We think the best way to approach the choice is by following three steps:
1) Find a strategy with a level of upside capture you’re comfortable with
2) Make sure there’s a complementary downside capture
3) Gain confidence that the manager can continue to deliver that experience consistently
It all comes back to a point we’ve emphasized before: Investors should know what they want when they’re looking for an alternative strategy. And they should identify the right manager who can consistently deliver the return experience they’re looking for.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.