How to explain alternatives’ place in portfolios to your clients

By viewing alternatives through the lens of the three primary colors, they can be demystified

Product proliferation. Endless streams of “innovation.”
Our clients have readily understood hopes, dreams and objectives — and our industry responds by pumping out increasingly complex products at a dizzying pace. I subscribe to a service that outlines the most recently registered investment products. The emails come relentlessly, day after day — and they are not short reads!
Unfortunately, this product firehose leads to more than just a logjam at the SEC — it can distract clients and financial advisers as they attempt, usually in vain, to keep up. Confident discourses on long-agreed-on investment principles can devolve into nervous tactical discussions about Product X’s merits, or the appropriate allocation to a mysterious yet touted new asset class.
Perhaps, like me, you believe more is not always better.
(Related read: Want more time? Trim client investment options)
How are we — seasoned professionals, let alone retail investors — supposed to sort through all of this? How can we differentiate between the shiny new products that are just another Wall Street fad, and those that can provide value to our clients?
This is particularly true of the growing list of products that fall under alternatives. Despite the high velocity of new product launches, advisers and investors don’t always understand what the word even means. How many times have we heard:
“Alternatives? What are they?”
(More insight: Visit Alternatives University for a deep dive on alts)
Investments categorized as “alternatives” may represent only 3% of today’s markets — but they are growing, fast. Broadly defined as anything other than a stock or a bond, more investors are using them, and still more ask about them with each passing day.
It can be hard to explain what alternatives are, because they encompass so much territory. Are they a category? Sector? Product? Yes, yes and yes, but what does that really tell an investor?
I will explore the merits of specific alternative products in subsequent articles. For now I’d like to step back and propose a simple framework around portfolio construction — one that can be tailored to each client’s specific situation, and one that can assist advisers in finding and positioning products (including alternatives) that add real value.
Hopefully it can also help weed out the fads!
I propose that a client’s needs and objectives tend to fall into three broad categories:
• Capital preservation
• Income
• Growth
We can view these as the “primary colors” of portfolio construction. While some clients’ needs may be adequately served in one of these categories, it is more likely that their situation requires a unique blending of these “colors.”
For instance, a young couple’s portfolio may be mainly aimed at growth, but because they are also saving for their first home, capital preservation elements may be involved. A recently retired client may be focused on income, but her portfolio may also blend elements of growth and capital preservation, depending on age and lifestyle.
Why is this helpful? Because once the proper blend is determined, it becomes the adviser’s role to diversify within each category appropriately. One size most definitely does not fit all.
I have written about the benefits of diversifying within income, but it’s no less true with the other colors. There can be substantial benefits to broader diversification within each category. We are all well-schooled in the traditional products usually used in these categories, such as:
•Capital preservation: Cash, T-bills, short duration bonds
•Income: Government bonds, investment grade corporate bonds, dividend stocks
•Growth: U.S. and international equities
However, when evaluating new products, it is critical to understand and analyze how and why the product works, and what specifically it adds to diversification. That the latest shiny Wall Street toy is new and different is not enough.
With this framework in mind, over my next three articles I will endeavor to evaluate the alternatives space. They may at first appear daunting, but there are many excellent alternative investment strategies that can improve portfolio performance and diversity.
By viewing these strategies through the lens of the three primary colors, my hope is to not only demystify alternatives, but help advisers explain to clients what role they can play in successful portfolios, and most importantly, how alternatives can connect to clients’ goals and objectives.
They often take a little more time and effort to understand fully, and as a result selling them to clients is not always easy. However, alternatives offer features and benefits that — especially in these uncertain times — clients want and need. Whether they realize it or not.
Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.