Strong returns for alternatives attract flows, but advisers should tread carefully

Financial advisers who are considering adding alternative investments need to remember that the point of these vehicles is to adjust the risk weighting between traditional stocks and bonds, rather than to provide strong returns, panelists at the Morningstar Investment Conference said Monday.

The alternatives category is broad and includes assets such as commodities and real estate, as well as more complex strategies such as options, relative-value and absolute-return strategies.

Alternative investments may be able to modify, diversify or eliminate the dominant risk produced by a traditional portfolio of 60% equities and 40% bonds, said Simon Scott, director of alternatives ratings and global manager research at Morningstar Australia. But as with any investment, there are potential benefits but also pitfalls.

HOW TO USE ALTERNATIVES

Advisers need to think about the risk they're seeking to address. Alternative investments that modify the traditional portfolio risk include equity strategies such as private equity and defined outcome solutions such as buffer funds or buy-write strategies. These may perform well when equities are rising. On the income or defensive side, strategies may include long-short credit, private debt or inflation-linked securities that will provide a modified exposure to the same core bond risk factors, Scott says.

Diversifiers aim to use nontraditional sources of enhanced return such as volatility or carry plays, or hedge-fund type strategies for long-term returns. However, Scott said, investors need to be careful because these strategies can lose money, especially during times of uncertainty.

Alternatives that try to reduce equity risk or attempt to be opportunistic when stocks are falling tend focus on absolute returns, aiming for positive returns in all markets, and focus more on capital preservation. These strategies are the most complex, he added.

DON'T CHASE RETURNS

The strong returns some alternative strategies saw in 2021, such as private equity, which was up some 50% as of the third quarter, increased flows to the sector, said Hilary Wiek, lead analyst of fund strategies and sustainable investing for PitchBook, a Morningstar subsidiary.

Morningstar noted a record $28.86 billion of net flows into liquid alternative strategies during 2021, and the first quarter of 2022 saw net flows surge by $13.55 billion — an increase of 53% over the prior quarter. Assets for the sector now total $159 billion.

Some of that increase was probably investors chasing return. But the Securities and Exchange Commission recently relaxed its rules about who can invest in these vehicles and is starting to allow alternatives in some 401(k) options.

Wiek said while those 2021 returns look promising, they’re not likely to last because alternatives will probably follow the weakness seen in the public market space this year.

She also offered other caveats for investors seeking to dabble into these markets, pointing out that alternative investments are opaque. Wiek noted that the return data PitchBook received in April was for the third quarter of 2021. Lock-up periods can range up to 10 years, and management fees of 2% over 10 years will cost $200,000 on a $1 million investment. How much investors pay depends on the size of the fund and the fund structure. A limited partner may charge one fee, but a fund of funds has fees that go to the limited partner and the general partner.

Finally, Wiek said, there’s wide variation between manager returns for the different types of alternative investments. She cited venture capital as a particular volatile example, with top-quartile managers having exceeded 35%, while the worst posted a negative 5%.

“If you pick the wrong manager, you're not going to even come close to getting the [return of the] median managers,” she said.

[More: Alternatives become a bigger piece of the pie as advisers seek shelter]

Debbie Carlson writes about investing, personal finance and retirement.