Follow the smart money to alts

If advisers are truly looking out for the best interests of their clients, the 60-40 portfolio approach needs to change

Oct 12, 2014 @ 12:01 am

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(Roger Schillerstrom)

Institutional investors — pension funds, university endowments and the like — are often called the “smart money” because, presumably, they have access to sources of information and investment products most financial advisers and individual investors do not. As such, many of those same advisers and investors look to institutions to identify hot investments.

For many years now, institutional investors have been using alternative investments to enhance their portfolio returns, diversify their holdings and cushion downside potential.

Some of these investments, such as private equity, remain the purview of those big investors because there's no vehicle structured for retail use.

Others, however — for example hedge fund strategies including long/short equity, global macro and the like — have trickled down, and many advisers are using them in their client portfolios.


Nonetheless, as senior columnist Jeff Benjamin points out, the traditional portfolio allocation of 60% stocks and 40% bonds (flipped for retirees) remains holy writ among advisers. If advisers are truly looking out for the best interests of their clients, however, that needs to change.

If the 2008 financial crisis and its aftermath taught investors and advisers one lesson, it should be the importance of portfolio diversification. There were few places to hide back then, as nearly all asset classes moved down in lockstep.

But investors lucky enough to be using tools to diversify and limit the downside potential of their portfolios were happy to have them.

For that reason alone, getting clients invested in alternatives would be a logical move. Add a market environment in which stocks are trading at lofty valuations and bond yields are poised to go nowhere but up, and the attraction of alternatives only increases.

Becoming knowledgeable about any new asset class and then educating clients takes time, but it is time well spent. In the case of what are known as liquid alternatives — alt strategies wrapped in mutual fund structures — advisers must fully understand the investment strategy, the managers using it and how it will help clients reach their goals.

So, the first step is due diligence. That cannot be understated because, as liquid alternatives grow in popularity, more and more firms are pumping out products — putting an even greater onus on advisers to know what they're buying.

That means contacting the firms, the managers and, for advisers at bigger companies, the gatekeepers at their own firms who green-light investment products that will be available to advisers. It means peeling off the wrapper to understand the underlying investment strategies and risk, and how much volatility is built into the strategy.

Many liquid alternatives lack long performance track records, so understanding the manager — on a firm level and on an individual level — is paramount.

Three of the questions that need to be answered:

1. Does the firm operate a star manager system or a team system?

2. What's the portfolio manager's process and track record?

3. Does the manager have practical experience running the strategy, or is the approach simply theoretical?

Once you fully grasp the product, you'll be prepared to present it to your clients and able to answer their questions.


The next critical step is determining how much of a client's portfolio to allocate.

As one investment strategist said, 10% is better than 5%, and 15% is better than 10%. If advisers simply make a 5% allocation to alternatives, it won't have the desired impact on the portfolio and won't be worth all the effort expended on due diligence — or the fees paid to use the strategy.

Theodore Enders, senior portfolio strategist at Goldman Sachs Asset Management, and Bruce Emken, a member of the Goldman alternatives sales team, recommend an alternatives allocation of between 19% and 24%. Exact allocations will depend on the desired outcome.

“Think of it as dabbling versus diversifying,” Mr. Emken said. “Adding a few percentage points of alternatives just to check a box is not doing anything.”


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