Gauging the value of an alternative investment has been a real challenge for advisers, particularly in the last eight years.
Looking at performance and fees doesn't tell the half of it. Liquid alt strategies are meant to dampen risk and/or magnify diversification — two things less appreciated in a tenacious bull market.
Most advisers get this intuitively, but financial crises cast short shadows, especially for some of your investing clients — and selling the more-expensive safety pitch when the bull is charging is tough.
It gets even tougher when the products and strategies grow in number and complexity, as they markedly have in the last decade.
Misunderstandings about the uses of alternative strategies in a broader portfolio have led some advisers to pick the wrong options and others to avoid considering them in the first place.
GROUNDSWELL OF CRITICISM
There's been a groundswell of criticism that
the DOL fiduciary rule, which requires advisers to act in the best interests of clients in retirement accounts, will actually halt the use of any strategies that aren't cheap, i.e., passive. But the reality is, being a fiduciary means ensuring that clients are in the best portfolio for their particular needs and risk tolerance. For many clients, that will mean the inclusion of downside protection in one form or another.
But how is an adviser to do the right kind of due diligence and find an alternative strategy, even just among the 484 liquid-alt funds currently on offer?
(Related read: A comprehensive, searchable database of advisers' fiduciary FAQs)
Luckily, new tools —
particularly Morningstar Inc.'s coming style boxes for alternative mutual funds — are beginning to break the plane of otherworldly dimensions many advisers relegate alts to.
NEW BOXES
Advisers and investors are familiar with the fund snapshots Morningstar offers for traditional equity funds, which denote investment style and size. The new boxes for alt funds will indicate a spot on a similar nine-square matrix, but this time measuring correlation and volatility relative to global equities.
Morningstar argues that merely considering a fund's beta doesn't tell enough of the story. A beta of 0.3 could hold true for two very different mixtures of standard deviation and correlation. If a primary goal for including an alt fund in a portfolio is to diversify the holdings, the correlation measure is surely the more important. If, instead, lessening the chances of severe losses is the principal concern, the volatility measure will be paramount.
Of course, glancing over a style box based on past performance won't be where an adviser's responsibility ends. It is, however, a useful addition to the process for deciding whether including an alternative fund in a larger portfolio is the best choice for a client.
ALTS' PURPOSE
An alternative strategy is only as good as what it is an alternative to. What is its purpose?
Determining this is the first step when considering alts. Next is understanding how a particular fund under consideration meets that purpose — which a style box and other tools can help clarify. The screens can go on from there: Who is the manager, fund family, and what are the strategies employed — and how might those react when the cycle shifts and we experience substantially different markets?
(Related read: The DOL rule kicks in. Will independent broker-dealers survive?)
Ignoring liquid alternative investment options or falsely comparing them with passive funds in a rising market isn't a thoughtful, long-term move. Only after advisers take the time to really understand the variety of alts out there and what each aims to do within a broader portfolio can they legitimately say alts are not in the best interest of this individual client I am here to help.
