15 Aug Why Alternatives Make Sense in a Portfolio: August 2017 Edition
When one considers Dennis Rodman, what typically comes to mind are his off-court exploits – most notably his trips to the communist state of North Korea. It’s hard to tell what Rodman is bringing to the table during these meetings other than something akin to being a court jester. But in this update, we’ll focus on Rodman’s on-court exploits and what he did for basketball teams he played for during the late 1980s and early 1990s.
What relevance does Dennis Rodman have to an investment portfolio? According to teammates and opponents, Dennis Rodman brought a valuable combination of defense and second-chance opportunities. In our mind, defense and second-chance opportunities in the NBA translate into investment portfolio benefits such as diversification, staying power, and optionality. We’ll discuss each of these concepts below, but the overarching concept is that all portfolios could use more Dennis Rodman.
We’ve written about the concept of diversification in recent publications as the S&P 500 has been one of the best-performing equity indices over the last eight years. There was a confluence of factors, to include stable currency, political stability, and savvy corporate management, that contributed to this positive outcome for US equities. Yet, as we sit here at the midyear point in 2017, the winds of change are blowing in favor of companies domiciled outside the United States. Consequently, in many alternative strategies we have implemented in portfolios, the correlation/diversification benefits are starting to become more apparent.
The crux of the argument relating to diversification benefits is seen clearly in the mathematics of a portfolio drawdown. We illustrate this concept below, displaying the return required to get back to even based on various levels of portfolio drawdown.
Essentially, if you can construct a portfolio in a way that reduces the drawdown by owning non-correlated assets, you allow the math to work in your favor. We believe alternative assets/strategies are an effective way to mitigate portfolio risk.
This concept may be new to many clients but it is one that we’ve been thinking a lot about recently. Staying power is a behavioral concept that has application to every long-term investment portfolio and refers to the idea that portfolios will either succeed or fail due to investor behavior during stressful market periods. As we’ve all witnessed over the years, we know people who can’t handle watching their portfolio losing money. How many people do you know that sold out of all their equity exposure during the financial crisis and haven’t repurchased yet, or they have only recently added it back while equity markets are at all-time highs?
All this being said, if a portfolio contains assets/strategies that are zigging when the market is zagging, an investor’s ability to remain invested in the “riskier” portion of their portfolio goes up dramatically. This staying power could be seen in the win/loss record of almost every team Dennis Rodman was on over his career, due to the fact that Rodman was a master at keeping his teams in the game with both tenacious defense and rebounding. These two traits took the pressure off the superstars that surrounded Rodman. We believe that a properly diversified allocation to alternative assets/strategies has the potential to reduce pressure on the more volatile segments of a portfolio (typically equities) over a full market cycle.
Finally, we believe that all portfolios should be constructed with a degree of optionality. Optionality is the flexibility a portfolio has to make changes or adjustments during significant stress periods in the financial markets. The way in which most portfolios possess optionality is via a cash position. Cash is said to have a high degree of optionality because the “price” of cash does not fluctuate and is readily accessible to redeploy in the event opportunities arise on very short notice.
Optionality is an important characteristic to have in a portfolio primarily because it allows investment decisions to be made without external influences. For example, we believe investors like Warren Buffett and Seth Klarman have enjoyed success partly due to the fact that their portfolios carry a significant amount of cash (optionality) at almost every point in time. In the case of Seth Klarman (via his investment vehicle Baupost LLC) the average level of cash over the last 30yrs has been 20%. In the case of Buffett (via his investment vehicle Berkshire Hathaway) that cash level has been even higher! The point in mentioning these levels is that both Klarman and Buffett have been able to succeed because they are almost always investing in opportunities based on merit. Further, when they are making investments, they do not need to sell something to free up capital. In this way, they are making only one difficult decision (what to buy) and not two (what to buy and what to sell). Optionality is something investors should consider, as we currently find many equity and fixed income markets at extended valuation levels.
In summary, every team needs a Dennis Rodman, just as every portfolio could benefit from alternative holdings that generate a return that is different from traditional stocks and bonds. While the benefits described (diversification, staying power, optionality) above may not be intuitive in the midst of an eight-year bull market, these benefits are invaluable during periods of significant market distress. To that end, even though we have no way of knowing when the next significant downturn will come in the financial markets, that doesn’t mean we shouldn’t begin preparing for the next occurrence.
The above article is intended to provide generalized financial information; it does not give personalized tax, investment, legal, or other professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other matters that affect you or your business.
 In fairness, I cannot claim credit for the idea of correlating Dennis Rodman with alternative strategies. That idea came from Chris Cole of Artemis Capital. On the Artemis Capital website under “Market Views,” you’ll find a very interesting publication entitled “Dennis Rodman and the Art of Portfolio Optimization.”