Few topics are more divisive in the financial advice community than the use of alternative investments. It is right up there with active versus passive investing and buy-and-hold versus market timing.
But while some advisers will staunchly deny or ignore any potential benefits of alternatives, often using arguments related to fees, those who are open to the notion of alternative investments still frequently get stuck when it comes to deciding how and how much.
How much to allocate to alternatives is both an unanswerable question in general and one that absolutely needs to be addressed specifically for each client.
While it would be difficult to say for certain how much each investor should allocate to alternatives, there is some consensus that allocating 5% or less will have almost no effect on a portfolio.
“It's pretty easy to make the case that alternatives should be at least 20% or 30% of a portfolio, but we know that those kinds of allocations are rare,” said Cliff Stanton, chief investment officer at 361 Capital. “But at the same time, just dipping a toe in the water with a 5% allocation to alternatives really isn't going to help.”
For most financial advisers new to the concept of using alternative strategies, the trouble begins the moment they start looking at the category. Even though alternatives have moved down-market over the past several years in the form of liquid alternative mutual funds that employ a wide of range of alternative strategies, a lot of advisers remained focused on the roaring equity markets.
But as stock market volatility has kicked in and the Federal Reserve moves ever closer to raising interest rates for the first time in a decade, more advisers are starting to glance in the direction of alternatives.
The trouble is, unlike more homogeneous long-only stock and bond products, alternatives come in a lot of different flavors. And unlike the oversimplified asset allocation strategy that loosely divides a portfolio of stocks and bonds based on an investor's age, so far there is no such rule when it comes to alternatives.
“For a moderate-risk portfolio, one could make the case that many traditional 60-40 portfolios could include a 20% allocation to alternatives,” said T.P. Enders, managing director and head of the portfolio strategy team at Goldman Sachs.
“But for a client that has never invested in alternatives before, it will be difficult to get him or her to 20% in alternatives overnight,” he added. “In our view, it's pretty hard to make a case that anything less than 5% in alternatives will have an impact on a portfolio, but in order to get to the answer of how much you need in alternatives, you have to start with the idea of what they are supposed to do for you.”
Alternative strategies can be used to manage or reduce the risk in a long-only stock or bond allocation, increase the performance of a portfolio, or target specific objectives such as income generation or inflation protection.
RISK MANAGEMENT TOOL
Looking past much of the distracting noise and hoopla related to alternative strategies that have been credited for taking outsize risks to generate outsize returns, a clearer picture emerges from simply considering alternatives as a means of managing risk.
“You have to ask if your client realizes how much risk he is taking in traditional asset classes, and that's when you start to realize you probably do need more in alternative investments,” said Dick Pfister, president and chief executive of AlphaCore Capital.
“Relative to what we've seen lately with stocks and bonds, alternatives look rather tame to me,” he added.
In fact, with the stock and bond markets looking rich, Mr. Pfister said it would be unrealistic to expect anything close to a 5% annual return without including alternatives in a portfolio.
But how much?
“I will tell you that 10% will not cut it,” he said. “Right now our composite model portfolio has a 55% allocation to liquid alternatives, but for most advisers, anywhere from 5% to 20% is a lot of exposure.”
Risk is also a driving force behind incorporating alternatives at 361 Capital, which is adopting a portfolio optimization platform to increase diversification using liquid alternatives.
“As we talk about using liquid alts, we're talking about reducing risk, because all returns come from risk in some fashion,” Mr. Stanton said. “We approach it from the perspective of which strategies have the highest probability of achieving those goals of risk reduction.”
It doesn't make matters any easier that the liquid alts universe has ballooned to more than 650 funds across 15 different subcategories, according to Morningstar Inc. That's up from 538 liquid alt funds at the start of the year and 427 at the start of 2014.
Sifting through that swelling universe can be an intimidating challenge for a lot of advisers, especially considering that these are not your garden-variety large-cap growth funds.
“A lot of advisers tell us they'd like to invest in alternatives but they don't have the time or the resources for the due diligence required,” said Nadia Papagiannis, director of alternative investment strategy for Goldman Sachs Asset Management.
“In some cases, alternatives might be just a 10% allocation, but it can represent 90% of the due-diligence resources,” she added.
AVERAGES OF LITTLE USE
Bob Rice, chief investment strategist at Tangent Capital, summed up the challenge of investing in alternative strategies by pointing out that “averages mean very little as a guide to how alternative assets perform because you don't take an average date to the prom, you take your actual date.”
His point is that the performance dispersion between the best and worst funds in a particular liquid alts category can be much greater than the performance dispersion seen in most long-only fund categories.
For example, the long-short equity fund category tracked by Morningstar has a one-year category average return of 1.7%, but the performance among the funds in the category ranges from a gain of 18.6% to a decline of 24.7% for a spread of 43.3 percentage points.
Over the same period, large-cap growth funds had an average gain of 3%, with individual fund performance ranging from a gain of 19.7% to a decline of 9.4%, for a spread of 29.1 percentage points.
In other words, being wrong with alternatives can potentially mean being painfully wrong, which is the kind of thing that will keep financial advisers, if not their clients, up at night.
Mr. Pfister, who uses liquid alt funds to help advisers introduce investors to alternatives, believes more than half a portfolio should be allocated to the asset class. Among his biggest challenges is making sure advisers and investors understand the give and take of allocating to alternatives.
“If I put somebody into a long-short equity strategy, I need the client to understand what that means because chances are it will not go up as much as the equity markets,” he said. “Sometimes it gets lost in the translation why clients have alternatives in their portfolio.”