Alternatives: A key piece of the investment puzzle

The case for traditional long-only allocations to stocks and bonds is getting weaker by the day, and that's putting the financial advice industry, if somewhat reluctantly, at the junction of major change. Embracing the change might not even be an option, but there's plenty of work and evolution ahead for advisers, particularly those stuck in the old ways of building client portfolios.

60-40: PARADIGM OF THE PAST

Considering the current state of top-heavy equity valuations combined with bond yields that can only go up, driving bond prices down, “the old 60-40 stock-bond paradigm is unlikely to work the way it has for the past 50 years,” said Jason Schwarz, president of Wilshire Funds Management. For a sense of the evolution, consider that there are now 468 alternative-strategy mutual funds managing more than $172 billion, versus 217 funds and $37.7 billion at the end of 2008, during the peak of the financial crisis. Most observers see the rapid growth in so-called liquid alternatives as just the beginning of where most of the action is likely to take place over the next several years. “More investors are starting to realize the old ways aren't working, financial advisers are starting to realize that traditional advice is becoming commoditized, and money managers are feeling the brunt of it all in the form of redemptions,” said Frank Muller, chief executive of Behringer Securities.

'STAY RELEVANT'

“The investment companies are grappling with changing fund offerings that are net positive for their businesses, and investors want lower volatility, so advisers need to redefine their value propositions,” he added. “The industry is flocking to alternatives to try and stay relevant.” At least some advisers are getting the message. Clients of registered investment adviser Money Management Services Inc. have been in alternatives for more than five years. Before 2009, allocations to alternatives were typically about 10%, but they have since climbed to anywhere between 15% and 30%, according to Andrew Rice, vice president and chief financial officer of Money Management. “Our clients like the liquidity,” Mr. Rice said. “Then, with the interest rate environment, people are looking for noncorrelated assets that can generate bondlike returns without the correlation to bonds and stocks. You have to have alternatives in there.” Against the backdrop of the current markets for stocks and bonds, Mr. Muller and others see a solid case for liquid alts' taking the retail investor market closer to the institutional investor market in terms of allocations to alternatives. Only about 3% of the $13 trillion invested in open- and closed-end mutual funds is allocated to alternative strategies, versus 24% allocated to alternatives by institutional investors. Applying those alternative allocations to the fund industry, and accounting for normal growth-rate assumptions, Mr. Muller forecasts that liquid alternatives will grow to over $8 trillion in the next decade. The aggressive outlook includes both a steady migration into liquid alts by institutional investors and an expansion into such products by private and limited partnerships, including hedge funds. A more conservative growth estimate from the Chartered Alternative Investment Analyst Association has liquid alts growing to 14% of the overall mutual fund marketplace over 10 years. “The investor is demanding lower-volatility portfolio performance with competitive rates of return,” Mr. Muller said. “If advisers don't meet those needs, they become irrelevant.” If the message sounds alarming, try to remember that it's more an evolution than a revolution. Brian Singer, head of the dynamic allocation strategies team at William Blair & Co., traces the beginning of the shift back 10 or 15 years and a “slow, emerging competence when the traditional space was still very plain vanilla and benchmark oriented.” “That is all fading away, because traditional managers are going long and short,” Mr. Singer said. “They're not charging [2% on assets and 20% of performance], and they're staying liquid. It's a great development for the industry, because it's a good thing for portfolio managers and investment advisers.” Of course, he added, the evolution comes with challenges, many of which financial advisers will have to shoulder. "The growth of and better access to alternatives provides more opportunities to manage risk,” Mr. Singer said. “But it also introduces a different type of due diligence, and that's the evolution that will take some time.” According to Mr. Muller, it will take lots of time. “This is going to be a 10-to-20-year challenge that will involve changing some of this wonky talking into stories and examples that investors can relate to,” he said. While the asset management industry works its creative magic and pushes the limits of how and where alternative strategies can be packaged in retail-friendly funds, advisers will have to familiarize themselves with a new investment vernacular, and explain the new universe to clients and fit it into portfolios.

GETTING IT WRONG

The risk for advisers is real, because it's possible to get alternatives very wrong. Unlike traditional long-only strategies that tend to rely on a lot of market beta, most alternative strategies are designed around capturing alpha (or return above a market benchmark) at the individual manager or fund level. That means performance dispersions can be dramatic between the best and worst liquid alternatives funds in each category. A study by Wilshire Funds of four traditional and four alternative strategies over the 10-year period through 2012 indicates that alternatives are not likely to move in lockstep, as traditional strategies often do. Among traditional investments, the 10-year annualized returns of large-cap, small-cap and international equities, as well as core fixed income, had top-to-bottom quartile dispersions of between 2.4% and 5%. But among alternatives — including relative value, macro, event driven and equity hedge — the top-to-bottom quartile dispersions over the same 10 years ranged from 15.7% to 19.8%. Ihor Szeremeta, director of alternative investments for U.S. wealth advisory at BlackRock Inc., says advisers need to focus their alternatives due diligence on four areas: the investment's risk-return profile, market exposure and beta, correlation to other assets, and manager skill and experience. “It's crucial to know what you own,” Mr. Szeremeta said. “How can you line up an investment with an objective if you don't know what the investment is?”

UNTESTED FUNDS

For now, the due diligence challenge with liquid alternatives is compounded by the fact that most funds have been launched since the beginning of the bull market. Therefore, they have never really been tested in anything but an up-market cycle. “We started back in 2006, 2007, and there were only a handful of long-short mutual funds,” said Thomas Meyer, chief executive of Meyer Capital Group, a fee-only investment management and financial planning firm in Marlton, N.J. Now, Mr. Meyer added, “it seems like we're getting five new products every day.” That fact is not lost on the likes of Brad Alford, chief investment officer at Alpha Capital Management. “Untested might be an understatement,” Mr. Alford said. “We're going on four years in liquid alternatives, and we're like a grandfather.” Keep in mind that, in addition to most liquid alts investments' being untested by a major market reversal, the performance of many hedging strategies has been lackluster at best when compared with the seemingly inexhaustible six-year bull market in stocks. “Let's face it — it hasn't been the best of times to lower beta in the portfolio,” Mr. Meyer said. “That's where the educational process comes in. Why we have this, why we pay higher fees. We have to put it on the table that these are shock absorbers. That's why we own them.” Keith Black, a managing director at the Chartered Alternative Investment Analyst Association, echoed that view. “There has been a lot of flows into the space, and performance relative to stocks hasn't been stellar,” Mr. Black said. Liquid alts will never keep pace with an equity market gaining 20% — or even 10% — a year, and in years when stocks and bonds underperform, liquid alts need to outperform. “As they do get tested, they need to be really different,” Mr. Black said. In addition, if they haven't already, investors and advisers should get used to the idea that the equity market will probably not maintain its current performance. “By almost every measure, the stock market is about 100% above its long-term average performance,” said Bob Rice, managing partner at Tangent Capital Partners. “It's not that I'm predicting a crash,” Mr. Rice said. “And the point of using alternatives isn't to predict the future. The point is to be prepared for many different possibilities.”

LOWER EXPECTATIONS

Though the stock market may take awhile to correct or crash, all manner of economic logic suggests that investors and advisers should at least expect lower returns than what they have become accustomed to over the past few years. With that in mind, liquid alternatives also open the doors to the flip side of hedging risk: enhancing returns. Even if a crash doesn't occur, “you simply can't expect the stock market ... to continue to throw off the same kinds of returns,” Mr. Rice said. “You want to reduce risk, but you will also need to find additional sources of returns.” Though he appreciates the hurdles advisers have to clear when they venture into alternative investments, he doesn't hold much sympathy for any adviser who isn't moving intentionally in that direction. “Advisers are going to have to choose wisely, because the performance dispersions with alternatives are radically bigger than in the long-only space,” Mr. Rice said. “But if you're an adviser and you're not seriously looking at alternatives, when all the math and metrics are staring you in the face, because it's hard or confusing or you just don't understand them, then you're not doing your job.”