Advisers are overdiversifying, and it's not doing their clients any good.
That's the mantra of advisers who continue to use a traditional stocks-and-bonds allocation strategy, despite the surge of money being turned to alternative investments.
“There's been pretty significant inflows in anything you can dress up as an alternative strategy in the past five years,” said James Osborne, the president of Bason Asset Management. “Everyone is looking for the silver bullet. Everyone is looking for returns without risk. From a performance standpoint, it hasn't been good for people to chase those returns.”
Investors have poured $156.6 billion into alternative investments, including nontraditional bonds, since 2010, according to data from Morningstar Inc. Nearly half of that amount — $74.6 billion — has come in 2013, giving the alternative market total net assets of $227.3 billion.
The driving force behind the use of alternative investments is this year's poor bond performance and an equity market that may be ready for a downward correction. Still, some believe that overdiversifying is unlikely to add value for clients.
“I think [overdiversification] is going on in spades,” said Fran Kinniry, a principal in
The Vanguard Group Inc.'s investment strategy group. “If equities do have a bear market, a lot of these things investors think will protect them … will likely underperform a high-grade bond fund.”
Vanguard has long contended that stocks and bonds are essential in an investor's portfolio and Mr. Kinniry maintains that logic, as long as the holdings are well-diversified and well-managed — in a 60/40 allocation or otherwise. One of the problems of bulking up on alternatives can be the danger of “doubling down” on an asset class that you already own. For example, it's probably not a good idea to buy real estate investment trusts when another of your strategies already holds those securities.
In addition, Mr. Kinniry is concerned about investors' tendency to shy away from bonds in the current bull stock market because of the low expected returns. Bonds are intended to preserve capital in case equities and other classes begin to take a downward turn, rather than to generate huge profits, he said.
One of the driving forces behind the increasing use of alternative investments is the uncertainty in the bond market, said Nadia Papagiannis, the director of alternative fund research at Morningstar Inc.
“Bonds are undergoing a huge liquidity crisis,” she said. “There's no guarantee that stocks are going to do well, either. If you perceive there's risk in the market and you want to hedge, a good way to do that is to diversify into alternatives.”
With the unpredictability of both elements of the traditional 60/40 strategy, Ms. Papagiannis said advisers would be wise to expand their portfolios elsewhere, especially in long/short equity, market neutral and managed futures strategies.
Still, some believe that overdiversifying is unlikely to add value for clients and maintain that sticking to stocks and bonds is enough.
“This idea that you need more [types of investments] doesn't hold out well,” Mr. Kinniry said. "You would be surprised at how a lot of these assets perform when the equity market comes under stress.”
Osterweis Capital Management, which manages $8 billion for high-net-worth clients, runs a Strategic Investment Fund (OSTVX) that follows a stocks-and-bonds strategy. John Osterweis, the company's chairman and chief investment officer, pegs it as an “alternative to alternatives.” He said the fund, which was founded three years ago, is gaining popularity. It holds $223 million in assets as of the end of October and has a 21% performance rate year-to-date, as of Oct. 31.
“60/40's been beating the geniuses,” Mr. Osterweis said during an interview. “I just have a feeling that the pendulum may be ready to swing back.”
Mr. Osborne said the bonds and stocks investment method he prefers is labeled “boring” by some. Still, it allows him to refrain from getting concerned over short-term ups and downs in the market or being tempted by the “silver bullet” strategies that come along.
“I don't think worry does a lot of people a lot of good in the long run,” Mr. Osborne said. “I work with my clients to stick to a long-term investment strategy. The rest of it is trying to tune out the noise and recognizing that this is a long-term game.”
