Sophisticated and naive investors alike are rushing into alternative investments as if they are the cod liver oil that will cure all the investment world's ills.
Most financial advisers who include alternatives in client portfolios do so because they are trying to solve some sort of investment problem. But all too often, they don't even know what problem they are trying to solve.
In this environment, most advisers say that they are interested in alternatives to mitigate the equity volatility in their clients' portfolios. They are trying to avoid a recurrence of the pain that their clients experienced in 2008 and the beginning of 2009.
The major problem with this approach is that the average investor's portfolio is overweight in bonds and underweight in equities, so protecting against exposure to stocks might have little real effect on returns.
Advisers who are trying to get ahead of the curve and prepare for the next crisis might want to pay attention to the bond portion of their portfolios and consider the likelihood of underperformance in that sector. In that case, an entirely different set of solutions would be required for protection against the volatility of the equity market.
Once advisers decide what problem they're trying to solve for a client, they must figure out what type of alternatives solution to use. For convenience's sake, we group a wide range of investing vehicles, representing different legal structures, investment ap-proaches and degrees of liquidity under the heading of alternative investments, but they are by no means the same.
As with any investment decision, due diligence is required. This point can't be understated, because in the world of alternatives, it seems that more is accepted on faith than in more traditional investments.
The complexity of many al-ternative investment approaches makes the role of the professional adviser crucial.
Many alternative in-vestment products have fairly high correlations to U.S. equities. Others have yet to be tested over a full market cycle and may not offer the downside protection that investors seek.
In terms of net flows, the biggest alternatives category right now is multistrategy, according to Morningstar Inc. These are portfolios in which a number of different strategies are packaged together into a single investment.
The adviser considering a multistrategy solution needs to consider a number of key points, including: Who is doing the packaging? Given the set of solutions inside the package, is it designed to solve for equity volatility? Bond volatility? Both? Is it over-diversified to the extent that it is dampening returns, as well as volatility and/or risk?
Over the past three and a half years, the multistrategy alternatives category has underperformed the S&P 500 by 3,600 basis points. Sure, in 2008, it outperformed the S&P 500 by 1,500 basis points, but that is still a shortfall of 2,000 basis points relative to the problem (equity exposure) that you are trying to solve.
FINDING THE RIGHT ANSWER
Advisers who are considering alternative investments in a client's portfolio first should sit down with the client and, together, arrive at a clear understanding of what problem they hope to solve with the allocation. Once they have answered that question, they should begin selecting the investments that are likely to mitigate some of those risks.
It is unlikely that a single multistrategy alternatives portfolio would solve every potential risk, and if the client and adviser were looking to solve both equity and bond risk, they likely would choose two different alternative investments.
When considering exposure to alternatives, another key piece of the due diligence is considering how allocations to different strategies are determined.
There are many valid approaches.
One that has had some success is to take a flexible approach, using a set number of managers, each of whom is given a portion of the portfolio to manage. Each of those managers then is given the freedom to decide dynamically how that allocation of capital is going to play out.
Alternative investments can be a valuable tool to help mitigate the risks inherent in a traditional investment approach. They can provide answers to many problems investors face, but only if advisers ask the right questions.
Gene L. Needles Jr. is president and chief executive of American Beacon Advisors Inc., and president of American Beacon Funds.
