Financial innovation provides investors with a seemingly endless supply of new investment options. But the process of evaluating the merits of these investments remains the same even as the names change. Adopting a new component in one’s asset allocation represents a tradeoff that should carefully balance the expected benefit vs. the cost of its inclusion. The following framework highlights benefits investors may seek as well as potential drawbacks—a checklist that applies to any investment opportunity.
Properly evaluating whether something belongs in your portfolio begins with specifying the role it is expected to play. These roles come down to a) increasing your expected return or b) helping manage risk.
If the objective is to increase expected returns, what is the case for the asset in question accomplishing that? It is easy to link a positive expected return with equities, for example, as stock ownership gives you a claim on companies’ future cash flows. Similarly, bondholders expect to receive periodic interest payments and the return of their principal as stipulated in the bond’s covenant. But an asset that lacks a sound foundation for delivering a positive expected return should give investors pause, regardless of its past performance.
Investors should also be wary of making assessments about expected returns in asset classes with limited data. Newer products with shorter track records give investors less information about what to expect in an asset class. Nonpublicly traded investments may pose additional hurdles due to a lack of timely market-based performance data. And, finally, the age-old difficulty in distinguishing between luck and skill is amplified in more-volatile asset classes.
Expected return may take a back seat in the case of an asset that helps manage risk. Professor Ken French defines risk as uncertainty about lifetime consumption. This uncertainty stems from many sources, including market downturns, inflation, and interest rate changes, to name a few. Risk- management assets should offer a robust way to mitigate the contributions from one or more of these contributors to uncertainty.
Investors should avoid “missing the forest for the trees” when hedging risk. For example, an asset class whose returns are correlated with inflation but are much more volatile than changes in the Consumer Price Index may not be an effective risk-management tool. You may be hedging unexpected inflation but still increasing uncertainty over future consumption due to the volatility.
Investments may also reduce portfolio risk if they increase diversification. But how should investors assess the diversification benefit? Although it is common to look at , investors may want to ask whether the investment expands their opportunity set. If you’re only invested in US stocks, then expanding the portfolio globally improves diversification. The global stock market is worth around $80 trillion.1 Global bond markets tack on another $125 trillion.2 This is important context for the size of potential additions to your asset allocation and may be a helpful starting point for determining how much to invest in the asset.
The benefit of adding something to your portfolio must outweigh the drawbacks.
An obvious drawback is high costs. Fees and expenses are typically transparent to investors, but it’s important to be aware of differences in fee structures. Traditional equity and fixed income mutual funds and ETFs usually use a flat percentage fee based on assets under management. Other asset classes may include performance fees. These structures may incentivize manager behavior in ways that are inconsistent with your investment objectives.
A less-transparent cost (at least on expectation) is the potential for adverse selection. Whether we’re talking about the latest initial public offering (IPO) or a private equity placement, the most desirable allocations will have a line out the door. Investors without access to the most desirable investments will be left with suboptimal selections. This challenge is compounded if high minimum-investment thresholds are imposed, which may preclude diversified exposure across investments.
An investment’s potential is more likely to be beneficial if you can stick with it through thick and thin. This is where complexity becomes a drawback. All investments go through periods of disappointing performance. The extent to which investors can endure these periods and stick with the investment plan may depend on how well they understand what drove performance. Transparency and trust tend to be highly correlated. All else equal, investors in opaque strategies or ones with less operational history may be less inclined to persevere in times of uncertainty.
Finally, there’s the cost of wondering about the road not traveled. Adding a new investment means giving up some of what you already have. That presents the potential for regret if the asset you’re giving up goes on a strong performance run subsequent to the change. For example, many investors were tempted to jettison value portfolios in the wake of value stocks’ decade-long underperformance vs. growth prior to 2021. Replacing value right before its historic run in 2021 and the first half of 2022 may haunt investors for years to come.
We can put this framework to use with a few examples of notable alternative asset classes.
The media fanfare around bitcoin has left many investors wondering if they should dip their toe in the cryptocurrency waters. A few aspects of our evaluation framework are instantly relevant.
Let’s start with the expected-return criterion. Little attention would be paid to bitcoin were it not for its meteoric rise in value in recent years.3 But it’s unclear why holding bitcoin should have a positive expected return. Bitcoin offers no claim on future cash flows, as one gets with a stock, and no promised interest payments, as one is entitled to with a bond. Future returns from simply holding bitcoin depend on it appreciating in value vs. another asset—the definition of a speculative investment.
It's also not clear bitcoin or other cryptocurrencies can help investors manage risk. Using Professor French’s definition of risk, it is difficult to imagine uncertainty over lifetime consumption being reduced by an asset that has, multiple times, fallen in value by double-digit percentages in a single day.
Another consideration is the size of the bitcoin market, which, at around $384 billion,4 is about 0.2% of the market value of global stock and bond markets. To put that in perspective, a $1 million portfolio composed of global stocks, global bonds, and bitcoin at market-cap weights would hold only about $2,000 in bitcoin.
Managed-futures funds typically hold diversified futures contracts tied to various stock and bond indices. These strategies are often touted as diversifiers for traditional asset classes. While they may have low correlations with traditional equity portfolios, it is not because they expand an investor’s opportunity set; futures contracts are derivatives whose value is determined by the performance of the underlying asset. Derivatives may alter the so-called payout function of the asset, such as reducing downside exposure by forfeiting some potential upside, but they generally do not offer exposure to asset classes outside of traditional portfolio components.
Costs are another consideration with managed-futures strategies. An academic study5 on managed-futures funds reported a gap between before-fees and after-fees measures of average returns of 4.52 percentage points per year. That’s a lot of performance being squeezed out before it can land in an investor’s hand.
Thematics represent a broad class of investment strategies that generally target themes, providing exposure to narrow subsets of the market, such as individual sectors or companies touted as potential beneficiaries of long-term economic trends.
Proponents of thematic investing may subscribe to a high-expected-return story rooted in the premise that these investment styles are ahead of the curve. This is essentially a market-timing proposition, and the historical data are not kind to the success of market timing. Thematic funds therefore may not increase expected returns for investors already possessing exposure to the equity market.
It’s also not clear thematic strategies increase diversification. For example, one thematic ETF focuses on companies expected to benefit from COVID-19-related paradigm shifts (work from home, attention to health, etc.). These aren’t new sectors—investors with globally diversified equity portfolios are likely holding these stocks already.
Type I errors in asset allocation changes are expensive. Replacing an investment you once believed in with a shiny new product that doesn’t pan out is potentially detrimental to achieving your financial goals. A consistent evaluation framework helps investors mitigate the chance of this regret. These evaluation criteria can also be customized to individual preferences. After all, considerations like liquidity needs and risk tolerance often vary through an investor’s lifetime.
At the end of the day, this framework is about asking the right questions, which, as researchers will tell you, is just as important as the answer itself.