Gaining more in up markets than you lose in down markets is at the heart of success in alternative investments. It’s not magic—the secret is an effective blend of market and nonmarket returns.
The difference between success and failure in alternative investments usually comes down to a manager’s skill. Specifically, designing a strategy that delivers an effective blend of market returns (beta) and nonmarket returns (alpha) is imperative to achieving investors’ objectives.
UPSIDE/DOWNSIDE: WHY IT MATTERS
As we’ve discussed, the up/down capture ratio helps illustrate why alternatives, on the whole, have outperformed traditional 60/40 stock/bond portfolios over the long haul. It’s not easy to consistently grab more of the market’s upside than its downside. In most cases, alpha is the key ingredient—how much value does a strategy add beyond market exposure?
If we look at a hypothetical equity portfolio, we begin to see the power of up/down capture.
By definition, an index represents the market, so we can think of an equity index as capturing 100% of its own return upside and 100% of its own downside. That’s an up/down capture ratio of one. If an equity investor’s portfolio takes on 100% market risk and the market rises by 10%, the investor gains 10%, too, solely from market exposure.
ADDING ALPHA TO THE RETURN MIX
What happens if that investor’s portfolio also generates 3% in alpha each year? (To keep things simple, we’ll assume that all the alpha comes in up markets and none in down markets.)
With the extra alpha, when the S&P 500 Index is up 10%, the equity portfolio will typically be up 13%: 10% market plus 3% alpha. When the market falls 10%, the portfolio is down 10%. In statistical terms, this portfolio captures 130% of up markets and 100% of down markets (Display 1). The up/down capture ratio, then, is 130 to 100, or 1.3. By being effective at generating alpha, the manager of this equity portfolio has designed a solid upside/downside return experience.
But the historical appeal of alternatives has been their ability to provide downside protection. Sure, alpha is an important part of the up/down capture ratio, but when we start to consider hedging away market risk, the importance of the specific alpha/beta blend becomes clear.
HEDGING MARKET RISK TO IMPROVE THE BALANCE
Let’s say the manager of the equity portfolio (the one with the 130/100 up/down balance) decides to start a long/short equity portfolio for investors who want downside protection. One way to do this would be to base the new strategy on her long-only portfolio, then hedge away 80% of the market risk.
Of course, investors have to give up some return potential to eliminate 80% of the market risk. When the S&P 500 is up 10%, the portfolio will only return 2% because of its lower market exposure. But the long/short portfolio still retains all of its security-specific risk, which drives alpha. So, the portfolio still generates 3% alpha in up markets. Its overall return is 5%, equivalent to half the market’s 10% gain.
If the market declines by 10%, the power of the downside protection kicks in. The long/short equity strategy loses only 2% (20% of the market loss and no loss from alpha). By hedging market risk, our manager improved up/down capture experience to 50/20, a ratio of 2.5. That’s almost double the ratio of the long-only equity portfolio.
DISTINGUISHING RETURNS FROM RISK-ADJUSTED RETURNS
All things being equal, higher up/down capture ratios generally mean better risk-adjusted returns. But they also mean absolute returns will likely be lower in the long run. That’s because markets tend to rise over time—and the more market risk we remove, the lower the absolute return is expected to be. But as more of the return comes from alpha, in principle the risk-adjusted return should also be higher.
The results from the hypothetical portfolios over the past 15+ years (Display 2) reinforce this story. The 130/100 portfolio has much higher overall returns, but the 50/20 long/short portfolio scores much better on other metrics, notably volatility (standard deviation), risk-adjusted returns (Sharpe ratio and the similar Sortino ratio, which measures only downside volatility) and maximum drawdown.
Both the 130/30 and 50/20 would have beaten the S&P 500 over a 20-year period and produced higher risk-adjusted returns. But the 130/100 topped the equity index by winning more; the 50/20 did it by losing less.
Which path is better? It depends on investors’ individual preferences for upside potential and downside protection. To put it another way, is it ultimately more important that investments build wealth or defend it? How does each investor choose to balance those two goals?
THE BETA TRADE: WHO TOOK MY ALPHA?
If alternatives offer the potential for better up/down capture ratios, why don’t more investors use alternatives today? We see a couple of reasons.
First, in the lengthy equity bull market after the financial crisis (the “beta trade”), alternative solutions with downside protection probably seemed unnecessary to many investors. And second, the beta trade’s environment of high market returns, low volatility and low return dispersion made it harder to generate alpha and harder for that alpha to keep pace with beta.
We think that environment is already changing and the beta trade is winding down. With valuations looking stretched and volatility rising, investors will likely rediscover the need for downside protection. In these conditions, pursuing alpha through active management—and alternatives in particular—makes more sense.
But buying into this concept and expecting any alternative strategy to magically be perfect for their needs isn’t enough. Investors should know what they want when they’re searching for the right alternative investments. This includes understanding the very specific risk and return experience they want, then identifying the alternative investment or investments best suited to deliver it.
It’s also critical to review the available options carefully: there are many different alternative strategies to consider in the hunt for the right mix of alpha and beta.
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.