cliffwater research - portfolio diversification through liquid alternatives april 2014

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Cliffwater Research – Portfolio Diversification through Liquid Alternatives of 9 © 2014 Cliffwater LLC. All rights reserved.

Less obvious are smaller asset classes or security types that technically might be grouped with stocks or bonds but which have sufficient unique or unfamiliar qualities that many investors might consider them to be alternative. These include REITS, MLPs, TIPS, and covered call strategies. Correlation is the statistic most commonly used to identify alternative investments. Alternatives are investments whose returns have a low correlation with stock and bond portfolios. A low correlation means that returns produced by the alternative investment exhibit a pattern that is different from stocks and bonds, and therefore, if included, would serve to diversify the overall portfolio. The correlation statistic ranges from +1.0 to -1.0. A +1.0 correlation identifies two sets of returns that directionally follow each other perfectly, and therefore offer no diversification. A zero (0.0) correlation identifies two sets of returns that have absolutely no relationship with one another, and therefore offer great diversification. A correlation equal to -1.0 occurs when the two sets of returns move in perfect but opposite directions. Cliffwater uses the correlation statistic as the defining test of whether a strategy or asset class is an alternative investment:

A strategy or asset class is “Alternative” if its correlation is equal to or less than 0.75.3 Our definition is based on the notion that alternatives should have low overlap with common stocks, the driver of a traditional portfolio. Correlation does not directly measure overlap but its mathematical square (2), also known as R-squared, measures overlap. More precisely expressed, R-square equals the proportion of risk found in one return stream that is explained by the index return stream. We selected a 0.75 correlation as our alternatives benchmark because its square (R-squared) equals 0.56 (56%), which approximately fits our notion of alternatives as producing a return stream different from stocks. Our definition would include private equity, real estate, hedge funds, and most real assets as alternative. Emerging markets, small cap stocks, and high yield bonds are examples of investments that we would not include as alternatives. A Catalogue of Alternative Investments Our definition of alternatives allows for potentially hundreds of strategies and niche asset class. A useful way to think about alternatives is to split them into “alpha driven” and “beta driven” groupings, as we do in Exhibit 1. Our purpose is to source the underlying driver of low correlation. Alpha measures value-added returns produced by a manager’s active decisions. By definition, it is uncorrelated with traditional index returns because it derives from idiosyncratic security risk which is not present in index returns.4 Alpha driven alternatives have high alpha and low beta content and generally are structured as hedge funds. Hedge fund managers generate alpha primarily by utilizing traditional asset classes (i.e. equities, high yield, and Treasuries) in non-traditional ways, such as expressing an opinion regarding the direction of an asset class or security through long or short positions, or through leverage or hedging. The average individual hedge fund has a correlation equal to 0.45 when measured against equities.5 Alternative beta-driven investments refer to less well known asset classes whose returns are also less correlated to stock returns but the cause is primarily a difference in the type of beta return. Alpha is a

3 We measure correlation against the nearest traditional asset class, which would be a stock index such as the MSCI ACWI (global) Index for most alternative investments but could be a bond index such as the Barclays Aggregate Index for fixed income strategies or asset classes. 4 Idiosyncratic risk is also known as unsystematic risk, as opposed to systematic or beta risk. 5 Hedge fund correlations increase as the number of funds increase because alpha risk declines from diversification while beta risk does not. This phenomenon also helps explain why hedge fund-of-funds performed poorly for many years as they over-diversified.

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Cliffwater LLC

Cliffwater Research – Portfolio Diversification through Liquid Alternatives of 9 © 2014 Cliffwater LLC. All rights reserved.

Like the Core Alternatives portfolio, each of the satellite alternatives portfolios offers a better risk-adjusted return compared to any combination of stocks and bonds. Investors with individual preferences for income, inflation-protection, or safety, might consider combining the satellite absolute return, alternative income, or inflation-protection portfolios with the core alternatives portfolio for their alternatives allocation within their overall portfolio. Conclusion Investors have few good choices among traditional asset classes to diversify their stock and bond portfolios. Alternative investments, on the other hand, offer strong diversification potential, lowering risk measurably without sacrificing return. However, selecting from the broad range of alternatives can be a challenge, even for the experienced investor. We recommend a multi-alternative, multi-manager approach that maximizes the diversification potential from the various alternative assets and strategies. We also recognize that investor preferences differ, and bespoke satellite alternatives portfolios, such as income-oriented or real asset, might be more appropriate alternative investments either alone or in conjunction with a core alternatives portfolio.

Stephen Nesbitt CEO

Cliffwater LLC [email protected]

The views expressed herein are the view of Cliffwater only through the date of this report and are subject to change based on market or other conditions. All information has been obtained from sources believed to be reliable but its accuracy is not guaranteed. This report is being distributed for informational purposes only and should not be considered investment advice, nor shall it be construed as an offer or solicitation of an offer for the purchase or sale of any security. The information we provide does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Past performance does not guarantee future performance. Cliffwater is a service mark of Cliffwater LLC.

Expected

Return

Expected

Risk

Return

/Risk

60/40 Portfolio 5.90% 10.92% 0.54

Core Alternatives 6.88% 7.10% 0.97

100% Stocks 7.55% 18.00% 0.42

100% Bonds 2.40% 4.00% 0.60

Inflation Protection 6.70% 10.05% 0.67

Alternative Income 7.12% 9.03% 0.79

Absolute Return 4.85% 4.95% 0.98

cliffwater research - portfolio diversification through liquid alternatives april 2014

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