Alongside the other major asset classes, says portfolio theory.

Few people, by definition, are GOATS. The acronym for the Greatest of All Time applies to Kelly Slater with his 11 world titles in surfing. Same for the quarterback Tom Brady with seven Super Bowl titles. Don Bradman too with his 99.94 Test batting average.

In May, the accolade was used for the late Jim Simons (1938-2024) – ‘Farewell to the GOAT’ was the headline of The Economist article on his deeds¹. His achievement? He changed Wall Street with his way of alternative investing.

Simons, armed with a PhD in maths, in 1978 founded Renaissance Technologies so he could apply his theory that patterns existed in the ways bonds, commodities, currencies and stocks traded. He built computer-based quant models to plough through data to make money.

Simons’ returns were so huge – an average 66 per cent annual average for the first 30 of his Medallion fund – that others tried to mimic his alternative-investment techniques². Such success and efforts are among those that have driven the rise of alternatives as credible investments options.

What might people mean by ‘alternative’ when it comes to investing? The term refers to any investment strategy that offers an option away from investing in the traditional asset classes of bonds, cash, equities and property.

Alternative investments can be defined as those that invest in anything in any way with an aim to generate a positive return (as distinct from positive relative returns; when someone beats a benchmark). Alternative investments can be global macro strategies, event-driven approaches, hedge funds, short-selling strategies, private ownership of equity and debt in companies and, Simons-like, quant-driven trading strategies.

The next question to ask is: Where might alternatives fit in a portfolio? The answer lies in the work of another recently deceased investment guru, Harry Markowitz (1927-2023). The US economist was awarded the Nobel memorial prize for economic science in 1990 for developing portfolio theory³.

Markowitz’s genius were his thoughts on the relationship between risk and reward. His brilliance was to see that a portfolio’s risk was based less on the riskiness of each asset found in a portfolio but depended more on how these assets related to one another. Markowitz’s work led to the acceptance that asset allocation was the major determinant of a portfolio’s risk, not security selection within each asset class.

The concept that diversifying across asset classes lowers portfolio risk is now the cornerstone of investing. (See chart below.) Time has shown the major asset classes of bonds, cash and stocks perform differently and the right mix can steady returns. Further diversification can be gained by diversifying within asset classes.

Where might alternative investments fit into this thinking? Alternative assets are those that seek to deliver positive returns unrelated to the performance of any market benchmark. This feature means their returns are typically uncorrelated to the returns of the other major asset classes, especially if further diversification in the alternative sleeve is garnered by diversifying across different alternative investment approaches. Based on this we believe that alternatives should form part of the primary (‘strategic’) asset-allocation decision.

A segment of a portfolio delivering consistent positive outcomes year after year, as most alternative investments seek to do, can give a portfolio a better risk-return profile compared with the same portfolio without alternatives. Including alternatives means too that investors can enjoy the returns of an equivalent, more concentrated portfolio, while taking less risk. Adding alternatives thus reduces the risk that investors will face capital loss, which better protects them from the behavioural bias of selling assets when they are falling in value – usually the worst time to sell. There’s a lot to like about alternatives.

Investment theory, to be sure, makes no recommendation as to the percentages of what should be allocated to any asset class including alternatives. The actual split depends on what risk-reward outcomes a fund manager hopes to achieve for investors. Asset-class correlations change with circumstances. No one can assume alternatives will perform as hoped.

But, by including alternative investment managers with some fraction of the skill of the GOAT Simons, investor portfolios enhance their ability to deliver their targeted risk-reward outcome over the longer term.

[1] ‘Farewell to the GOAT.’ The Economist. 16 May 2024. economist.com/finance-and-economics/2024/05/16/how-jim-simons-revolutionised-investing

[2] ‘Jim Simons, math genius who conquered Wall Street, dies at 86.’ The New York Times. 10 May 2024. nytimes.com/2024/05/10/business/dealbook/jim-simons-dead.html

[3] ‘Harry Markowitz, Nobel-Winning Pioneer of Modern Portfolio Theory, Dies at 95.’ The New York Times. 25 June 2023. nytimes.com/2023/06/25/obituaries/harry-m-markowitz-dead.html