February 10, 2011

Diversification Now: The Case for Liquid Alternative Investments

As market volatility persists despite rebounding asset prices, advisors are rightly questioning the impact of diversification. Today, diversification must mean more than multiple asset classes, it also includes alternative investment strategies that until recently have been available only for high net worth investors.

Demand among advisors for alternative strategies has never been greater, and for good reason. Alternatives provide access to both non-traditional asset classes and “alternative beta.” Alternative strategies seek to deliver non-correlated returns, thereby increasing portfolio diversification and dampening volatility. In addition, alternative portfolios use tools and strategies not available to long-only managers. This flexibility opens up the toolbox for skilled managers to potentially achieve a more attractive risk and return profile through the use of derivatives, leveraging, selling short, or just investing with a less constrained “style-box” focused approach.

One of the challenges with alternatives, however, is access. Typically, alternative strategies are structured as private partnerships that require investors to have an “accredited investor” status, come with high investment minimums, and include fees that can range between 1% and 2% of the fund’s net asset value per year plus an incentive fee of as much as 20% of gains.

Additionally, many alternatives have lockup periods, making them illiquid investments. Finally, there is often little transparency into holdings, leading to difficulty in evaluating and understanding the portfolio’s underlying risk.

For most advisors, the result of all this is that alternative strategies are very difficult to use in a portfolio, at a time when more investors want alternatives exposure. Even large institutions have struggled with the risk and fee variables that can complicate the portfolio construction process.

This is where liquid alternatives come in. In recent years, we’ve seen a proliferation of hedge fund-like investment strategies that are available in a liquid, transparent structure such as mutual funds and exchange traded funds (ETFs). Such portfolios make it possible for advisors to tap the advantages of alternatives for almost any investor: fees are lower, there are no lockups, and full transparency is available on a quarterly basis. The case for liquid alternatives is strong.

Yet access to alternatives is only part of the story. The challenge remains for advisors to navigate this growing alternatives universe, evaluate the merits of these strategies, and construct portfolios to maximize their benefit. With so many liquid alternatives to choose from, advisors must gain a deep understanding of the strategies to achieve a high enough comfort level in order to use them, but this can be intimidating . Our next column will delve into the classification of different alternative strategies and how to implement them in a portfolio. 

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