The biggest role that alternatives can play in a portfolio is in reducing the portfolio's overall volatility so that investors can have the confidence to stay invested.
“Individual asset class volatility is relatively normal, but portfolio-level volatility is actually quite high,” Nathan Rowader, director of investments and senior market strategist at Forward Funds, said Monday during a panel discussion at the InvestmentNews Alternative Investments Conference in Chicago.
The correlation between traditional stocks and bonds is higher today than it has been historically. With the balance thrown off of a classically constructed portfolio, it increases the chances of investors' panicking and making bad decisions.
“The No. 1 enemy of a portfolio is an investor themselves,” Mr. Rowader said.
“By keeping the portfolio volatility low, you can keep them properly invested through market cycles,” he said. “That's where alternatives play a role.”
The bond side of a portfolio is getting increased attention from financial advisers, given the increased volatility of interest rates and the potential of rising rates causing losses that investors may not be used to.
“We're at the end of a 30-year bull market in bonds,” said Steven Young, vice president at Jackson National Asset Management LLC.
“If you're a bond investor, you probably want to acknowledge that and do something in your portfolio,” he said.
The Barclays U.S. Aggregate Bond Index, a benchmark for investment-grade bonds, has a yield of about 2.4%, suggesting that over the next five years, that is the expected return.
It is a far cry from the 9% annualized returns that bond investors have become used to over the past 30 years. Making matters worse is the fact that the choppy rise in rates means that volatility is going to be higher too, and as we have seen this year, returns can even be negative.
“Bond market risk isn't the same as stock market risk,” Mr. Young said.
“You're not going to lose half your money, but it's the most conservative investors who are probably most invested in bonds,” he said. “You can get some difficult phone calls when bonds are down 3% or 4%.”
When it comes to allocating to alternatives, it helps to think of the allocation as a dial, Mr. Rowader said.
“Five [percent] to 20% is a great target, but 5% is just the tip of the iceberg. You can't do a lot with 5%,” Mr. Rowader said.
“Think of it as a dial,” he said. “Ask: What can this client tolerate now? And if it's successful, you can dial it up more.”