In July, we published a review of alternative investment funds (“Tough Choices: Alternative Funds in 2015”) that tracked the year-to-date performance of 68 seasoned “alts” over a dozen categories ranging from risk parity through commodities.

July’s appraisal provided a sort of telescopic view of the alts space. By that, I mean we zoomed in for a close-up of each individual category’s performance, on a stand-alone basis, rather than in combination with other assets that might be in an investor’s portfolio.

But that got me wondering: Could we get a different perspective on alts if we put them in harness with stock and bond exposures in a real world simulation? In other words, what kind of alternative investment would have been most useful as a portfolio diversifier over the past five years? 

I used market-weighted performance in the July analysis to better reflect investor behavior. So, in keeping with that notion, I’ll use each category’s largest fund as an exposure proxy in this study. The premise here will be simple: How will a modest (15 percent) allocation to an alternative strategy impact a balanced stock-and-bond portfolio? 

A balanced portfolio is classically defined as 60 percent stocks and 40 percent bonds. If we steal an equal amount of space from each allocation for alts, we end up with a 51 percent dollop of stocks and 34 percent for bonds. And, if we plot efficient frontiers based on the daily returns for each asset over the past five years, we end up with the prospective portfolios depicted in Table 1.

What’s an Efficient Frontier?

What’s an efficient frontier? It’s a set of portfolios mixing prescribed assets in such a way as to offer the highest expected return for a given level of risk. The set, based on the assets’ realized returns, standard deviations and cross-correlations, is plotted as a line on a graph. A portfolio lying below the efficient frontier would be considered sub-optimal because it wouldn’t be expected to generate sufficient returns for the level of risk assumed.