To make sure that alternatives are making a difference in a client's portfolio, financial advisers should allocate between 10% and 20% of their entire investments to alts, according to Nadia Papagiannis, director of alternatives fund research at Morningstar Inc.
Any move into alts should start with an allocation of at least 5%, but in order to have any kind of real impact, that allocation should grow to at least 20%, she said as part of her presentation last Monday at the InvestmentNews Alternative Investments Conference in Chicago.
“Five percent is really not going to make a difference, but 20% will start to make a difference,” she said. Steve Medina, head of global asset allocation and senior portfolio manager for John Hancock Financial Services Inc., said that if an investor is not at least 10% invested in alternatives, “you're not moving the dial. It should be upwards to 20%.”
“Different alternatives have different risk and return profiles. Different alternatives behave differently,” Mr. Medina said.
“Know what you own,” he said.
“But how much is right for my portfolio? Own enough to make a difference.”
As part of a pre-conference presentation designed to provide a lay of the land with regard to alternative investments, Ms. Papagiannis told the audience of financial professionals to be diligent and to diversify into alt strategies.
“If I were doing it, I would pick an equity long-short strategy, a managed-futures strategy and a market-neutral strategy as a kind of bond substitute, and I would equal-weight them into the portfolio,” she said. “Prior to 2008, a lot of investors were too heavy into equities, and now a lot of advisers are telling me their clients are too heavy into bonds.”
Mr. Medina's panel also discussed how advisers should fund the allocation.
In the past, advisers would have considered reducing their exposure to equities because of the correlation between some hedge funds and stocks.
But with the end of a 30-year bull market in bonds, advisers should think about funding alternative investments by reducing clients' allocation to fixed income, one panelist said.
“We're taking money away from fixed income to fund hedge fund allocations,” said David Reichart, head of business development for the Principal Funds. “Historically, you would have taken it away from equities.”
Using 'worst idea'
Mr. Medina noted that funding for alternative investments can also come from the adviser's “worst idea,” or area of the market he or she dislikes the most during that time period.
At the beginning of the year, that area was Treasury inflation-protected securities.
“Ask yourself, 'What is my worst idea?'” he said.
“This year, we hated TIPS. You can allocate the client's exposure to alternatives investments from the worst idea,” Mr. Medina said.
Regarding funding clients' exposure to such investments, he said that advisers should consider funding half from equities and half from bonds to balance the portfolio better.
“If you fund alternatives 100% from bonds, you'll get better returns but get an increase in risk,” Mr. Medina said.
“If you fund 100% from equities, you will reduce the overall risk, but there's a cost to that, and you will hold back a little bit of total return over time,” he said. “Therefore, start with the concept of funding half from equities and half from fixed income.”