Alternative investment strategies including private equity, hedge funds and absolute return, have doubled since 2005 into a $7.2 trillion worldwide category, according to McKinsey, the consulting firm. While institutions surveyed by McKinsey held one quarter of assets in alternatives, individuals hold only 3% on average.

Now, a wave of new products created for individual investors in the form of "liquid alts," mutual funds and ETFs opens new vistas for investors and new challenges for advisors seeking to master the widening field.

U.S. assets in liquid alternatives, are still relatively tiny, at approximately $300 billion, yet alternative mutual funds accounted for more than one-third of U.S. mutual fund net flows in 2013, according to Morningstar.

Alternatives' popularity among institutional investors has not been driven by superior performance, notes McKinsey.

"Gone are the days when the sole attraction of alternatives was the prospect of high-octane performance," according to The Trillion Dollar Convergence, a McKinsey white paper. "Investors are now turning to alternatives for consistent risk-adjusted returns that are uncorrelated to the market. They are also increasingly looking to alternatives, or alts, to deliver on other crucial outcomes like inflation protection and income generation."

The relative profitability of alternatives for investment managers and product originators guarantees that the deluge of new products will continue.  To help advisors wade through the new products, wirehouse firms and mutual fund companies have begun education campaigns to explain why portfolios can benefit from alternatives and how to pick the right funds.

ALTERNATIVES ON THE RISE

With stocks high and interest rates likely to rise, the argument goes, alternatives deserve a bigger place in many portfolios. The marketing mantra is that investors need "risk-adjusted returns," and so the pressure is on for advisors to consider alternatives to replace part of a client's stock or bond holdings.

Some industry professionals suggest plowing a lot more into alternatives than the average allocation of 3%. "We think 15 to 20% of assets in alternatives [is] a general answer, depending on what else the client owns," says Daryl Dewbrey, head of business development for UBS's Alternative Investments.

Last year, Merrill Lynch alone sold $26 billion of alternative products, both liquid and illiquid, to its wealth management customers. The firm noted that private equity and hedge funds grew 40% this year through June.

Keith Glenfield, head of Bank of America Merrill Lynch's Alternative Investments Group, says there is strong momentum across all alternative offerings. "Private equity and 40 Act [mutual] funds have been very strong, but in the past six to nine months hedge funds are coming back."

For advisors, trying to evaluate the constant flow of new liquid alternatives is like sipping water from a fire hydrant. Advisors considering replacing part of a client's traditional portfolio with alternatives should know that some research shows that they have as much chance of hurting their clients' risk-adjusted performance as helping them. The data shows in these alpha-driven strategies fund selection is critical.

Last year, a marketing frenzy surrounding alternatives prompted FINRA to issue an investor alert, "Alternative Funds Are Not Your Typical Mutual Funds," describing the challenges of evaluating liquid alt funds for potential risk.  FINRA cited the use of derivatives and short selling, the complex strategies pursued in many funds and the wide variety of securities held in certain vehicles.

The SEC announced in August that its Office of Compliance Inspections and Examinations would scrutinize 20 to 30 firms offering liquid alt funds. The agency has begun a "sweep examination" to examine liquidity, back office procedures and marketing, all to ensure that the industry is in compliance.

DEFINING ALTS

It's no secret that despite their growing popularity, there is some confusion about what alternatives are, probably because they are not an asset class. Rather, alternatives are vehicles that rely on investment strategies that either reduce risk while targeting a positive real return via hedged positions, or enhance returns through outsized increases in value. The latter is typically accomplished through private equity, real estate, infrastructure, venture capital and other opportunistic investments. 

Alternatives have long drawn ultrahigh net worth clients who have allocated significant portions of their portfolios to illiquid partnerships and stuck with them during the worst of times.

"We had an experience where clients were pleased with how hedge fund portfolios performed in 2008," says Merrill Lynch managing director and private wealth advisor Jerry Klein, based in Century City, Calif. "The drawdown in our hedge funds was less than one-third of the markets. It stops you many times from selling at the bottom."

Now, growth in alternatives is picking up across all investor types. Alternative strategies packaged to conform to mutual fund regulations within the Advisors Act of 1940 aim to bring alt-like returns to a much broader swath of individuals. ETFs also are in the game.

Chris Bricker, head of alternative investments at AllianceBernstein, says alternatives that dampen losses in times of market stress play an important psychological role.

"At its heart, this is an exercise in getting an appropriate amount of portfolio diversification so that the investor can stay invested," Bricker says. "If I have instruments in my portfolio that can enable me to reach my end goal more smoothly ... I can stay the course." UBS's Dewbrey adds: "Our approach is to use alternatives to make the lows higher."

ROLE OF ALTERNATIVES

Josh Charney, an alternative investment analyst at Morningstar, says the first step for advisors is to make sure traditional client portfolios are properly diversified across all asset classes, "and then look to alts to solve a problem these other assets can't solve."

"The allure of the asset class is that it looks so great on paper," Charney says. "It's so enticing, investors can jump in without doing the proper amount of research." He cautions that it is important to have realistic expectations for absolute return or hedged strategies. "It's a really slow grind with alts — low risk and low return."

A look at 29 liquid alternative funds with 10-year track records concludes that half the vehicles, when added to a fully diversified portfolio, increased performance per unit of volatility between 2004 and 2013. The other half didn't.

The research, published by the Investment Management Consultants Association and prepared by Craig L. Israelsen, a Financial Planning contributing writer and executive-in-residence in personal finance at Utah Valley University, found that lowering the pain threshold in market downturns comes at a cost in performance. Even the funds that effectively improved return per unit of volatility did so at a sacrifice of 1 or 2% or more of performance annually over the 10-year period.

Managing volatility, even with a performance price tag, may be right for some clients. Merrill's Klein says performance isn't everything for many clients. "I'm there to smooth out the ride," he says.

RATIONALE FOR ALTS

Morgan Stanley's wealth management strategy team predicts that in the next seven years, returns from a typical balanced 60% stock/35% bond/5% cash portfolio could be 40% lower than in the past 25 years, with a 35% increase in volatility.

"Sometimes stocks and bonds become correlated to each other," says Lisa Shalett, head of investment and portfolio strategies for Morgan Stanley Wealth Management. "In the world that we're now living in, of increased complexity, there may be a role for a fourth leg of the stool."

That leg, Shalett suggests, is alternatives. "The question isn't ‘how much am I going to make?' It's ‘will this alternative strategy mitigate the risk in the rest of my portfolio?'"

Morningstar's Charney sees the risk to fixed-income portfolios also warrants a look at alternatives. "A poor bond market outlook is the best reason to look to allocate to total return type strategies," he says.

The goal of risk mitigation in the short or medium term applies differently to different clients. Those at or close to a draw-down phase may be a better fit for hedged alternative strategies than younger clients still in a wealth-building mode. "There's no one-size-fits-all," Shalett says.

REASONS FOR SKEPTICISM

But not everyone is convinced.

One high-profile skeptic of the idea that alternatives should play a bigger role in client portfolios is David Swensen, chief investment officer of Yale University and architect of its aggressive use of alternatives.

"I worry that these alternatives we're talking about will be another high-cost way for individual investors to underperform," he says. Fees for liquid alternatives are relatively high. For example, the price tag for most long/short equity mutual funds runs over 2%.

Swensen's 2005 book, Unconventional Success: A Fundamental Approach to Personal Investment, suggests that a balanced exposure to global growth funds, fixed income and disciplined rebalancing are hard to beat for most individuals. He still feels that way and remains a fan of indexing and asset diversification.

"Yale has never viewed the mean return for alternative assets as particularly compelling," reads the Ivy League university's 2013 annual report on its endowment. "The attraction of alternatives lies in the ability to generate top quartile or top decile returns."

In other words, getting exposure to the best asset managers in alternatives is a great strategy. Investing with the other 75% may not be. Yale's 20-year return through June 2013 of 13.5% per year compares with the average endowment's 8.4%, as measured by Cambridge Associates. More than half that difference is attributable to manager selection, according to Yale.

Swensen worries that most investors will find themselves in funds that are average at best. "Beating the market is really, really, really hard," he says.

Yale's 2013 endowment report takes his comment a step further. "The costly game of active management guarantees failure for the casual participant," it says.

SELECTION PROCESS

To Swensen's point, the success of an alternative investment is highly dependent on the skill and resources of the particular fund manager.

The difference in performance between the best and the worst manager is much greater in alternatives than in, for example, a large-cap U.S. stock mutual fund. So, the decision to invest in private equity has less influence on a client's portfolio than the choice of which fund to invest in.

The task of sorting through alternative investment options is so important and so difficult that many institutions like pension funds and endowments, which have their own teams of investment professionals, hire outside consultants to help with the task. Understanding this, the major wirehouse firms are adding staff to assist their financial advisors in choosing the right managers for their investors.

Glenfield, Merrill Lynch's alternatives head, underscores the importance of manager research. "The level of due diligence on all the strategies is critical," he says. "The dispersion of results is even higher than in liquid stock funds."

Wealth management firms are offering road maps to advisors wanting to understand how best to put alternatives into client portfolios and how to find quality managers. Merrill provides detailed presentation materials with supportive data and clear charts to help advisors understand the various options in alternatives and how they fit into a client's portfolio. Morgan Stanley's Shalett also stresses the importance of advisor education.

"Our implementation guide gives very prescriptive advice on the strategies and managers clients should choose from," Shalett explains. Morgan also recently expanded its alternatives manager research to include liquid alt funds.

"We play the role of curator, not product developer," she says. "We evaluate these offerings for viability, suitability and appropriateness for our clients. Just this year, we formed a dedicated team to evaluate exclusively liquid alternatives in ETF and mutual fund products."

AllianceBernstein has started a "micro-site" to help advisors understand how to strategize alternatives. "We believe that as alts occupy 10 to 15 to 20% of portfolios, it will require a lot of skill, a lot of due diligence on the part of advisors," Bricker says.

KNOW THE RISKS

While the last five years have been good for stocks and bonds, it only takes a moment to think back to the financial crisis and be reminded of the need to hedge your portfolio. But that doesn't make alternatives a slam-dunk solution.

The idea of using alternatives as buffers against market drops is challenged in an analysis by Niels Pedersen and his colleagues at Pimco, published in the May/June issue of Financial Analyst Journal.

"Alternative assets have significant exposure to the same risk factors that drive stock and bond volatility," writes Pedersen, a senior vice president in the firm's client analytics group. High return strategies such as private equity and venture capital depend on valuations in public markets for an exit strategy. Real estate and infrastructure returns compare with fixed-income investments and depend on capital markets for liquidity.

"The bottom line," Pedersen continues, "is that alternative investments are much more volatile — on a mark-to-market basis — than their reported index returns would suggest." Outsized performance and capital preservation are rarely found in a single strategy.

Charney, the Morningstar analyst, points out that "with long/short, you can't actually have your cake and eat it, too.

"In an alternative fund, there's a lot more room for potential error. In a long-only stock fund, 90% of performance is from beta and 10% from stock selection."

The MainStay Marketfield Fund's (MFLDX) performance this year shows how alpha can go wrong in a hedge fund. The largest fund in Lipper's alternative long/short equity category, it has $20 billion under management, has a four-star rating from Morningstar, and has a bronze analyst rating from Charney.

MainStay protected investors from the worst of the 2008 declines  and performed well in the market rebound until the end of 2013. But in 2014 it declined about 5% by summer, with long and short bets not paying off. "They've been right for many years," Charney says, "and have a very good process. The fund has beaten the category on a risk-adjusted basis."

MainStay Marketfield continues to have a low correlation to the S&P 500, meeting its mandate as an alternative with a three-year beta of 0.31, compared with a beta of 1 for the market. According to Money Management Institute and Dover Financial Research, five liquid alternative mutual funds accounted for three quarters of wirehouse 2013 net alternative fund sales. After MFLDX, the next four funds were Goldman Sachs Strategic Income (GSZAX), JPMorgan Strategic Income Opportunities (JSOSX), BlackRock Strategic Income Opportunities (BASIX) and BlackRock Global Long/Short credit (BGCAX). Net flows into those five funds were $20 billion in 2013.

YING AND YANG OF LIQUIDITY

Merrill Lynch's Klein believes the best returns from alternatives can be found when investors tie up funds for the long haul. "I really think the only persistent alpha is a function of liquidity," he says. "You can invest in certain esoteric situations that can give returns above the markets. I would say that's true across strategies." But the risk of illiquid funds is that clients may not have access to cash if they need it, and funds are not marked to market every day.

Merrill's Glenfield says the same: "If you can afford to have part of your portfolio illiquid, a lot of research underscores that you can find extra return."

Not everyone is jumping on the alternatives bandwagon. Wes Long, a former financial advisor and now executive vice president and head of client services at Wedbush Securities, takes a more cautious view. "Alternatives can have a place in some people's portfolios," Long says, "but people need to understand what they are investing in and if it meets their investment criteria."

Wedbush's client services team has not felt any pressure from its advisor force to step up alternatives offerings. "We see advisors using some alternatives to hedge portfolios and help with yield pickup," he explains, but adds, "overall, our advisor force is not participating much in alternatives. We're a pretty conservative firm. Our advisors don't want the illiquid stuff."

UBS's Dewbrey argues that many portfolios can benefit from the kind of diversification that alternatives can add.

"I talk about casting a wider net," Dewbrey says. "I don't know if inflation is coming, but if I add an alternative, my net is wider and I can capture more sources of returns in more market environments. It is meant to be complementary to the existing portfolio."

Wedbush's Long sums up: "The challenge is going to be to understand these products. The products will only become more complex. There's always going to be someone out there building a better mousetrap." 

Margo Epprecht, Chartered Financial Analyst, is a financial writer and former stock analyst.

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