While 2017 was a great year for stocks, it was mediocre for alternative investments. The benchmark index we often look at, the HFRI Fund-Weighted Composite Index, earned 8.5% last year. While that isn’t too bad, our alternative investments did not produce returns in that range.
Depending on the allocation within your alternative investment portfolio, your returns were likely between 1.5% and 7.5%. The performance gap between our alternative funds versus the HFRI index is mostly because of the way we invest. Our funds have very little exposure to the stock market. In fact, the correlation of returns between our funds and the S&P 500 is close to zero. The correlation of the HFRI index with the S&P 500 is close to 75%.
While this hurts our returns in a bull market, we believe it is a positive attribute over time. Alternative investments are much more expensive than stocks. So, it doesn’t make sense to pay high fees for something that largely tracks the stock market. Also, tracking the stock market reduces diversification. We own alternative investment funds because they are different from stocks and bonds. We want them to behave differently to reduce risk in the overall portfolio, and hopefully lead to higher long-term returns.
We have some funds that performed very well last year, and others that were quite poor. That is the nature of our alternative portfolio. Because the funds all have low correlation of returns with each other, there will always be some funds that do well and others that stink. That doesn’t mean we sell the stinkers. Today’s losers are often tomorrow’s winners. All investments go through cycles. Unfortunately, those cycles are largely unpredictable, so we find investments we are comfortable with for the long haul, and hold them through thick and thin. Over time we expect to get returns that are a bit higher than the bond market and a bit lower than the stock market, reflecting the risk we take on with alternative investments.
On the plus side, our private real estate funds and the funds using futures and options all performed quite well, earning double-digit returns. The multi-strategy fund and the alternative lending fund performed decently, earning low-to-mid single digit returns. On the negative side, managed futures and reinsurance both lost money in 2017.
We wrote earlier in 2017 about the reinsurance fund and the year of record insured losses for the reinsurance industry. That led to a loss of 11.2% in the fund we use. Our preferred managed futures fund lost 1.0%, but has had a string of bad years lately. That said, both of these funds have experienced very positive upcycles in the past, and we have every reason to believe they will be contributors to gains in future years.
The goal with our alternative portfolio is to smooth out volatility and to earn returns in excess of the bond market. Both of those objectives have been accomplished over the past 5-7 years, even if returns have been a bit below what we would like. We expect alternatives to really earn their stripes in the next volatile stock market phase.
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