Financial advisers miss the mark by measuring alternative investments against stock market

It's no different than comparing stocks to bonds.

There are plenty of reasons for financial advisers to be leery of alternative investments, but most of them are related to a lack of understanding and comparisons to the wrong kinds of benchmarks.

In the wake of an unprecedented bull market for stocks, it is easy to just focus on the relative underperformance and higher fees of alternative-strategy mutual funds.

The average liquid alternative mutual fund, as tracked by Morningstar, has an expense ratio of 1.823%, which compares to 1.179% for the average large-cap growth fund.

And if you start drawing comparisons between liquid alt funds and some of the exchange-traded funds that offer broad stock market exposure for less than a dozen basis points, the case for alternative investments gets even weaker.

The liquid alternatives space doesn’t do itself any favors by responding to gripes about fees by pointing out that hedge funds and other private investment strategies typically charge 2% management fees and take 20% from the gains.

Keep in mind that the liquid alts space is still relatively new to investors. Ten years ago there were 132 liquid alt funds managing $32.6 billion, and today there are 484 funds managing $171.6 billion.

(Related read: Special report: alternative investments)

That growth rate occurred during a stretch when most investors would have been fine just sitting in a long-only portfolio of stocks and bonds. But looking back is not how most financial advisers allocate client assets, which helps explain the robust growth of alternatives.

Of course, there are sufficient naysayers who are still stacking the performance of alternatives against inappropriate benchmarks like hedge funds and stocks. Viewed from that angle, liquid alts will rarely impress.

For the three-month period through September, the Hedge Fund Research HFRI Fund Weighted Composite Index gained 2.96%, while the S&P 500 Index gained 3.85, and the Wilshire Liquid Alternative Index of liquid alt funds gained 1.29%.

Over the first nine months of the year, the HFRI hedge fund benchmark gained 4.19%, the S&P rose 7.82%, and the Wilshire liquid alts index increased 2.16%.

The hedge fund industry, which is already seeing a threat from the lower-cost liquid alts, is expected to outperform the mutual fund counterparts.

That’s part of the so-called illiquidity premium, according to Jason Schwarz, president of Wilshire Funds Management. “If hedge funds can’t outperform liquid alts, there’s no reason to give up the liquidity and pay the higher fees,” he said.

Mr. Schwarz will be discussing these topics in much more detail next month in Miami at the InvestmentNews Alternative Investments conference.

Comparing liquid alt fund performance to the stock market makes as much sense as comparing the stock market to the bond market.

The fact that the Barclays Capital Government/Credit Bond Index gained just 42 basis points in the third quarter hasn’t sparked a mass exodus from bonds because bonds are part of a diversified asset allocation strategy.

Clearly, much of the growth of alternative strategies since the 2008 financial crisis, when most asset classes collapsed in sync, has been driven by a renewed focus on diversification, along with fears of bubbles for both stocks and bonds.

Some financial advisers saw the payoff of the diversification into alternatives in the wake of the late-June Brexit vote.

Between June 24 and June 27, when a traditional portfolio of 60% stocks and 40% bonds fell by 2.7%, the Goldman Sachs Liquid Alternative Investments Multistrategy peer group fell by just 80 basis points.

“The liquid alts space hasn’t done a good job of setting expectations or managing expectations,” said Mr. Schwarz, who says most liquid alt strategies are still measuring their performance against either hedge funds, stocks, or cash. “It’s almost as if benchmarking has been put off as a day-two or day-three plan.”

It’s now at least day four, and the liquid alts space seems to be growing in spite of its myriad flaws.

Financial advisers are expected to dig deep in their evaluations of any investment. But when it comes to liquid alts, a lot of advisers might not be digging deep enough if they’re being side tracked by faulty comparisons.