Alternative investments have never been as readily available to financial advisers as they are today.
But for many, implementing the strategies in a portfolio may seem as daunting as solving a Rubik's Cube that has been deep fried in secret sauce.
In a recent survey by Natixis Global Asset Management SA, just 25% of advisers said they regularly use alternative investments.
The main reason cited by the other 75% for not regularly using alternatives was a lack of understanding.
It isn't hard to see how alternative investments could seem overwhelming. More than 400 liquid alternatives, which are hedge-fund-like strategies offered in a mutual fund wrapper, are available, up from a few dozen prior to the financial crisis.
And custodians are making it even easier to invest in the real McCoy hedge funds, private-equity funds and nontraded real estate investment trusts. Fidelity Investments, for example, launched its alternative investments platform for advisers just last month.
Why there is such a push to increase alternatives is the easy part for advisers to understand. The perceived struggles that a traditional portfolio of stocks and bonds will face in the future are apparent.
The stock market's epic run since the financial crisis is now nearing the end of its fifth year, and many observers think it is unlikely that returns will continue to be as robust. On the other side of a plain-vanilla portfolio, bonds face the well- publicized risk of rising interest rates.
Instead, it is the how and when to use alternatives that are the biggest questions advisers face.
The first step is usually the hardest for advisers, said Christine Johnson, director of alternative investments and asset allocation at Deustche Asset & Wealth Management.
“The first question has to be: What's the objective?” she said.
“It can't always be return. Alternatives aren't going to keep up with a bull market,” Ms. Johnson said.
That has been apparent this year.
The Morningstar MSCI Composite AW Hedge Fund Index, an asset-weighted composite of nearly 1,000 hedge funds, was up just under 5% through the first three quarters of this year. The S&P 500, meanwhile, rallied almost 20%.
DAMPENING RISK
So instead of using alternatives to chase returns, advisers should use them to drum down risk and volatility, said Nadia Papagiannis, an alternatives analyst at Morningstar Inc.
“The more risk-averse a client is, the more alternatives make sense,” she said.
For those conservative investors, Philip Roberts, a wealth manager at Round Table Services, likes funds of funds.
Funds of funds, or multialternatives as they are known in the liquid-alternatives world, combine a number of hedge fund strategies into a single fund, making it a one-stop shop for an alternatives bucket in a portfolio.
“It gives you immediate diversification,” Mr. Roberts said.
One thing to be careful of with such funds, though, is their fees. The underlying managers get paid a management fee, as well as the manager selecting the funds.
The average expense ratio of such funds is 1.85%, according to Morningstar.
Ms. Papagiannis prefers strategies that are hedging volatility, such as long/short equity funds that buy puts to protect the downside, she said.
One such fund is the $7.9 billion Gateway Fund (GATEX).
Its five-year annualized return of 4.6% significantly trails the S&P 500's 15% return, but in 2008, it lost only 13.9%, compared with the S&P 500's 37% drop. That is important because it lessens the risk of an investor's freaking out over the losses and locking them in at the worst possible time by getting out of the market at the bottom.
REPLACING BONDS
Glenn Myers, chief operating officer at The MDE Group Inc., increasingly is looking at alternatives as a way to replace bonds in conservative portfolios.
“We're at the end of 30 years of falling interest rates,” he said. “We need creative ways to control volatility and get returns without relying on a large allocation to fixed income.”
The biggest challenge with that is finding a way to replace the income from bonds, Ms. Johnson said.
“Alternatives will reduce the volatility, but they're not a yield replacement,” she said.
Nontraditional bond funds, such as the $443 million Iron Strategic Income Fund (IRNIX), have become increasingly popular for yield replacement this year. These funds aren't tied to a benchmark, so they are able to invest anywhere. But Ms. Papagiannis warns that the funds tend to take on a lot of credit risk and therefore are likely to be affected if the stock market goes down.
Alternatives aren't just for conservative portfolios, though.
To give his clients' portfolios more “octane,” Mr. Roberts prefers merger arbitrage strategies.
Merger arbitrage, such as that found in the $2.8 billion AQR Diversified Arbitrage Fund (ADAIX), looks to take advantage of the spread that develops when one company offers to acquire another.
Ms. Johnson likes long/short equity, which still has some market beta for aggressive clients.
Younger investors could also benefit from the more illiquid strategies, such as private equity or private real estate, because their long investment horizons mean that they don't need to worry about the liquidity, Ms. Papagiannis said.
