Alternative strategies boomed after crisis, but haven’t been tested

Closing in on the 10-year anniversary of the start of the financial crisis, and the stock market peak that preceded it in the fall of 2007, alternative-strategy mutual funds linger like an umbrella waiting for a storm.

Alternative funds, which are commonly known as liquid alt funds, began popping up following the peak-to-trough pullback that saw the S&P 500 index lose more than 56% from October 2007 through March 2009.

The initial appetite for hedging risk is illustrated in the growth of liquid alt funds.

The general category, which Morningstar has separated into eight subcategories, grew from 142 funds and $38 billion at the end of 2007 to 473 funds and nearly $165 billion today.

For some financial advisers that have been allocating client assets to alternative strategies to limit the impact of another market collapse, the conversations with clients get more difficult every time the S&P surpasses a new milestone.

“We’re feeling like this has been an unusual period of time, and we’ve lost some clients, but others are using us because they believe in our approach,” said Norman Boone, founder and president of Mosaic Financial Partners.

Mr. Boone, who manages $600 million, has for the past seven years allocated about 30% of client assets alternative strategies.

Alternative strategies are generally designed to reduce market risk, although some strategies will try to soup up performance with leverage or even bet on a declining market.

But as Mr. Boone knows well, reducing market risk often means not keeping pace with the high-profile performance of something like the S&P, which is up more than 11% so far this year, and gained more than 260% from the market bottom in 2009.

So far this year, the best-performing alternative-fund category, long-short equity, is up 5.4%.

The long-short category’s 10-year average annualized return through August 14 is 4.3%, which compares to 7.9% for the S&P.

“Clients have been a little disappointed, but the reason we’re doing this is we felt we needed a diversifier and downside protection after 2008, and that hasn’t been tested yet,” Mr. Boone said.

Except for a few brief market pullbacks, advisers like Mr. Boone have had to just trust that their allocations to alternatives are an insurance policy that will eventually pay off.

Bob Rice, chief investment strategist at Tangent Capital, sees the growth and popularity of alternative strategies as a “normal cycle in financial life.”

“As usual, people looked in the immediate rearview mirror and loaded up on alternative funds, which was what they needed before the crisis,” he said. “Now they’re all disgusted because it hasn’t worked out because they’re not performing. That’s like saying a life boat isn’t performing on a ship that’s sailing in the sea.”

Mr. Rice believes advisers like Mr. Boone are doing the right thing for their clients.

“I think the classic long-short fund is a really appealing strategy right now, because we can all agree the market looks overvalued,” he said. “But the market can also get more overvalued, so you don’t want to be out of the game completely, and you want some downside protection.”

Hedging risk has been a difficult message to present to investors over the past several years, said Todd Rosenbluth, director of mutual fund research at CFRA.

“These alternative funds were designed to protect against another bearish market, and we haven’t had that yet,” he said. “Depending upon where you invested, if you got in early, you would have significantly lagged behind with these strategies, and you would have paid a lot to do that.”

The issue of fees is one that continues to dog the liquid alts space.

With an average expense ratio of 1.7%, liquid alt funds are not expected to ever close the gap between something like large-cap growth funds, which have an average expense ratio of 1.2%.

While the asset management industry has clearly tapped a rich vein in the liquid alts space, not all financial advisers are impressed with everything the market has been producing.

“We’ve been through more than 100 alternative funds over the past five years,” said Stephen Barnes, partner and chief investment officer at Barnes Investment Advisory.

“It’s been like searching for a needle in a haystack because of the way Wall Street has been pumping out the funds,” he added. “We’ve found that, after fees, a lot of the funds make little or no economic sense.”

Mr. Barnes manages $150 million in client assets, and over the past five years began adding alternatives to client accounts, which are now about 30% allocated to liquid alts.

“We may fall behind the stock market in a huge advance, but what’s important to us and our clients is not what we make on the upside, but what we keep when it gets really ugly,” he added.

Dick Pfister, founder and president of AlphaCore Capital, believes he is part of the solution, as a $250 million asset manager that launched its first liquid alt fund at the end of 2009.

“From the stock market bottom in ’09 till now, people have been saying the same thing, ‘just buy the market because you don’t need alternatives,’” he said. “Whenever you see an equity market run up people will argue that hedging doesn’t work. But just like in the late ’90s when people were saying hedging doesn’t work, it feels like the markets are getting really ripe, and I think liquid alts will come back into favor.”