If ever there was a case against an investment strategy limited to traditional allocations to stocks and bonds, it was the global financial market meltdown that unfolded last fall.
If ever there was a case against an investment strategy limited to traditional allocations to stocks and bonds, it was the global financial market meltdown that unfolded last fall.
The downturn that in a matter of months wiped out multiyear stock market gains is now being recognized by some as the turning point for future asset allocation and investment strategies.
Specifically, the argument for alternative investments is louder than ever, and financial advisers are perking up.
“We spent most of last year doing due diligence on managed futures and we thought we were moving fast, but apparently not fast enough,” said Brian McKibban, a financial adviser with Syverson Strege & Co., which has $210 million under advisement.
Managed-futures funds stood out as one of the few bright spots last year, gaining an average of 14%, while the S&P 500 lost almost 40%.
Mr. McKibban never got his clients into managed futures last year, but he did allocate to such alternatives as commodities, private-placement real estate funds and venture capital.
PREACHING DIVERSIFICATION
“We're constantly looking, but we're extremely conservative and cautious,” he added. “We preach diversification, but you have to be hesitant on how you seek it.”
For financial advisers, particularly those who have only known bull market cycles, the pursuit of diversification in the form of non-correlated investment strategies represents a whole new ballgame.
“Right now the market conditions are aiding in building the groundwork toward greater use of alternative investments,” said Sanjay Yodh, managing director of alternatives at Rydex SGI.
“In the 1990s, you saw a proliferation of alternatives in the institutional world because they were ahead of the curve,” he said. “Sometimes you need a major market change to motivate people, and even then it takes time to learn and understand something new.”
The alternatives end of the financial services industry has long argued that a lack of understanding and education was the main obstacle standing between most advisers and a greater use of such investments.
Of course, as the industry has preached education, it has also flooded the market with an endless stream of increasingly complex products and strategies, many of which have gradually migrated from institutional to retail investors.
Then there is the issue of the broader global market itself, which has expanded and evolved to the point where it is often difficult to distinguish alternatives from traditional investments.
“We're still looking for true non-correlated strategies and we're having a hard time finding them,” said Mark Willoughby, principal at Modera Wealth Management, which manages $410 million.
“In general, alternative strategies have worked well for us, but the whole thing kind of blew up last year,” he added. “We're finding a lot of mutual funds out there that claim to be non-correlated, but a lot them tend to correlate with the S&P 500, and traditional alternatives are not offering much diversification right now.”
Many financial advisers and their clients learned a hard lesson over the past several months about the new realities of investment product correlation.
“The correlation between a lot of asset classes has been increasing, and investors will need to find new strategies,” said Jeffrey Mindlin, chief operating officer at Advanced Equities Asset Management Inc., which oversees $500 million in separately managed account portfolios.
Mr. Mindlin's in-house research compared the risk and performance characteristics of international and U.S. stocks today with those of 25 years ago.
He found that in 1984, the correlation between the S&P 500 and the precursor to what has become the MSCI EAFE Index was 48%. That compares with a 92% correlation between the two indexes in 2009, the research found.
The increased correlation, Mr. Mindlin said, goes beyond just international and domestic stocks, with the trend spreading across market capitalizations as well as value-versus-growth distinctions.
He attributes the general increase in correlation primarily to globalization and the expanding indexed-investing marketplace.
“If [United States] and international stocks are twice as correlated than they were 25 years ago, investors need to find alternatives,” he said. “Modern portfolio theory is mainstream these days and everybody uses it.
“The increased correlation has made the job of financial advisers harder, and it's difficult to make a case right now for things like commodities and hedge funds, but the flip side is, it's more important than ever to get clients exposed to alternatives.”
Some financial advisers have been on board for a long time, and the past year has seen a significant increase in interest in alternatives.
But for others, old habits are hard to break.
“I only discuss alternatives with clients after all the other asset allocation requirements have been met,” said Kevin Young, a sole proprietor with $10 million under advisement.
“I have not changed my strategy even in this market,” he added. “I think the client takes on too much risk if you go right into alternatives.”
According to Rydex SGI's most recent survey of more than 500 advisory firms, 33% of the respondents said they plan to increase allocations to alternatives, and 37% said they had already done so.
The alternatives marketplace is clearly moving toward financial advisers, but it remains a delicate and sometimes awkward dance.
Leveraged exchange-traded funds, for example, which have seen an explosion in popularity among active traders over the past few years, have also been the focus of growing regulatory scrutiny.
“Less than 10% of investors should be using our products and we're not trying to convert buy-and-hold investors, we're trying to identify tactical investors,” said Dan O'Neill, president of Direxion Funds.
Direxion, which has $6.5 billion under management mostly in leveraged and inverse ETFs, is an example of evolution in the alternatives space.
“The 1990s was a buy-and-hold decade, but over the last 10 years the markets have disappointed people,” Mr. O'Neill said. “The market conditions have changed the way people invest now, that's why we tell people to buy and monitor.”
E-mail Jeff Benjamin at jbenjamin@investmentnews.com.
