The “Three Fund” Portfolio Part 6 – Alternatives

In the first five parts of this series, we have looked at a traditional strategic allocation. Today we will examine how alternative investments can improve portfolio performance.

I have found that a 25% allocation spread out over several outstanding alternative mutual funds (public hedge funds) can improve returns and boost risk-adjusted performance dramatically.  I have curated a list of five-star mutual funds and ETFs with at least five-year track records from the long-short equity, market neutral, long-short credit, multi-alternative, managed futures, options-based, tactical allocation, etc. categories which I use to create my alt portfolios.       

I don’t use the same funds for each risk model. Instead, each risk model uses an optimized blend of those funds with the following targets:

  • Aggressive = Max return at 10% Std. Dev.
  • Moderate = Max return at 7% Std. Dev.
  • Balanced = Max return at 4% Std. Dev.
  • Conservative = Max Sharpe Ratio (typically 2% Std. Dev.)

Let’s examine how alt funds impact performance. Here is the aggressive portfolio from September 1, 2015 through May 31, 2020 with quarterly rebalancing:

Vanguard Strategic Allocation

  • 8.9% annual return
  • 13.6% standard deviation
  • -19.6% max drawdown
  • 0.88 Sortino ratio
  • -1.7% alpha vs SPY

Equalized DGRO/DNL/AGG Strategic Allocation

  • 11.1% annual return
  • 12.9% standard deviation
  • -18.4% max drawdown
  • 1.19 Sortino ratio
  • 0.8% alpha vs SPY

Equalized DGRO etc + 25% Alts

  • 11.5% annual return
  • 11.3% standard deviation
  • -12.5% max drawdown
  • 1.50 Sortino ratio
  • 2.4% alpha vs SPY

Sortino and alpha (measures of risk-adjusted return) both improve with alts as does drawdown risk and standard deviation. Annual returns improve too, although most of that gain is negated by a slightly higher tax-cost ratio for the alt portfolio.

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