From the July 2012 issue of Research Magazine • Subscribe!

Alternatives Stay on Growth Path

Advisors, asset managers and institutions are increasingly turning to alternative investments to help clients boost returns while supporting the growth of assets under management, according to several separate studies released in late May and early June show.

“Institutional investors and financial advisors have significantly expanded their alternative holdings since the 2008 crash, and continue to view alternative investments as an important part of their portfolios,” said Scott Burns, director of ETF, closed-end fund, and alternative research for Chicago-based Morningstar, in a statement. “Growth has begun to slow, though, as investors have ramped up their allocations, and excitement may be cooling with the lackluster performance of alternatives relative to the overall market over the last few years.”

For sure, alternatives continue to gain assets, bucking the trend in U.S. equities: Alternative mutual funds had inflows of $23.2 billion in 2011($14.2 billion excluding the non-traditional bond category), while U.S. equity mutual funds bled $84.7 billion. Still, inflows were lower than prior years; alternative ETF inflows for 2011 were only $11.6 billion, the lowest level since 2006, while inflows for alternative mutual funds were $1.8 billion less than in 2010.

About 65% of advisors and 67% of institutions indicated that alternative investments are as important or more important than traditional investments, down slightly from the 2010 survey. Institutions indicated rising interest and investment in alternative investments in 2008, 2009 and 2010. But in the 2011 survey, there was some retreat: Among the institutions surveyed, 26% indicated they plan to allocate more than a quarter of their portfolios to alternative investments, down from 37% in the last survey.

Boston-based Cerulli says its annual examination of the retail alternatives and ETF marketplaces found that asset managers expect alternative mutual funds to comprise nearly 10% of all mutual funds within five years. Plus, this percentage should jump to more than 15% in 10 years.

In a separate study conducted by Practical Perspectives, a Boston-based consulting and research firm, financial advisors said they expect continued growth in their use of alternatives and nontraditional investments. Most advisors currently allocate up to 15% of a typical client portfolio to these products, which is likely to increase as advisors grow more familiar with their benefits and uses, the report concludes.

“Interestingly, the need to differentiate in a competitive marketplace was the leading driver in 2011, and is considered much less of a driver in today’s market,” said Alec Papazian, lead author of the Cerulli report, in a press release. “We attribute this to the fact that so many managers now offer these strategies. 2011 was a record year for alternative mutual fund product development with 95 new funds being launched.”

Cerulli’s latest research shows that the leading driver behind asset managers’ interest in alternatives—nearly 90% of advisors cite it versus fewer than 75% last year—is tied to investors’ need to optimize the risk-adjusted performance of their portfolios. Another significant driver, for 72% of advisors surveyed in 2012 versus 60% in 2011, is managers’ expectations regarding future capital-markets returns.

The Practical Perspectives study finds that financial advisors can be divided into three core segments based on the likelihood of using alternatives and nontraditional investments for clients: heavily engaged, 30%; moderately engaged, 34%; and minimally engaged, 36%.

The study also concludes that most advisors, 60%, are allocating 10% or less to these products, though advisor use of alternatives and nontraditional strategies has increased notably in the past two years.

“Alternatives and nontraditional investments are increasingly important to advisors in serving retail clients,” said Howard Schneider, president of Practical Perspectives and a co-author of the report, in a press release. “This growth has been spurred by the challenging capital markets and the expanded availability of these strategies in mutual fund and ETF formats.”

The firm’s research emphasizes that the desire to enhance diversification and lower portfolio volatility and risk are the main factors driving increased use of alternatives and nontraditional investments. Plus, most advisors use mutual funds or ETFs as the main vehicle for investing in alternative products.

The most important factors in selecting alternatives and nontraditional investments are the expertise of the investment manager and the low correlation relative to more traditional investments.

Need for Education

“The audience for alternatives and nontraditional investments is definitely expanding,” noted Richard Gauger of Practical Perspectives, a co-author, in a statement. “Yet many advisors still lack familiarity with these strategies.”

According to Gauger, advisor satisfaction is lagging “relative to the importance they place on factors such as wholesaler support, product research and due diligence.” There is a direct correlation between satisfaction with support and advisor use of these strategies, he adds, so “product providers and platforms should be focusing resources more effectively on key audiences.”

For its part, Cerulli says its research shows that distribution access and advisor knowledge are the largest challenges facing alternative managers. Still, many broker-dealers, in particular the wirehouses, appear very supportive of increasing the use of alternatives among their advisors. On average, wirehouses see allocations at only 4% among their advisor forces but would like this to increase to greater than 15%.

“Firms that are providing superior educational materials may find that this provides an advantage within the wirehouses, which are looking for help in increasing advisor adoption,” said Matthew Pickering, a co-author of the recent research, in a statement.

“Most advisors report that asset allocation education on how to incorporate alternatives into portfolios is the most helpful method to increase their adoption of these products. Firms that have a thoughtful approach to educating advisors will see increased flows,” Pickering added.

Strategic Bets

Though sentiment has cooled to more established equity-based alternatives, this has not been the case for non-equity-based strategies like managed futures and currencies, despite poor performance, according to the survey of 365 financial advisors and 264 institutions conducted by Morningstar and Barron’s in January.

Managed futures and currency mutual funds recorded inflows of $3.6 billion and $3.4 billion, respectively, in 2011, despite the fact that managed futures lost 6.9% that year, while currency funds lost money every year since 2008.

For the second year in a row, advisors cited managed futures as the asset to which they were most likely to increase their exposure, while currency funds didn’t make their top five. Institutions flagged managed futures as the third-most-popular strategy for increased allocation, while long/short equity (or debt) and private equity/venture capital were the top two strategies for increased allocation.

While still positive, flows into market neutral and long/short equity funds—two more well-established categories—saw far lower inflows in 2011 than in 2010, Morningstar says.

In addition, advisors and institutions agree that diversification has been driving alternative investments, while high fees and lack of liquidity hold them back. The study finds that a lack of liquidity was the greatest impediment for institutions, while advisors cited higher fees. Uncertain benefits and lack of transparency were also top detractors.

Over the years, the percent of advisors concerned about lack of liquidity has fallen sharply, from 60% in 2009 to 40% in the most recent survey, coinciding with the launch of many new liquid alternative products.

Advisor’s Outlook

Advisors are less comfortable with alternatives than institutions, as 23% of institutions and 30% of advisors allocated 5% or less to alternative investments in 2011, the Morningstar-managed research found. But, 19% of institutions and 5% of advisors allocated more than 40% to alternatives, indicating that there are more sophisticated investors in both groups.

Managed futures, global tactical asset allocation (GTAA), and long-short strategies are most important to advisors, while long-short, private-equity, and managed futures strategies are most important to institutions.

The selection of which alternative-assets products to use varies, depending on advisors’ level of independence, Morningstar says. For example, several advisors stated their home office dictates their selections, while others stated that they analyze larger market and economic trends

Some advisors mentioned teams of individuals or consultants, while others were independently conducting the research process and evaluating the success themselves. Advisors also said they value the manager’s and the fund’s past success and the client’s asset allocation needs when selecting a vehicle.

“Since I am an hourly fee-only advisor, I use mutual funds,” one advisor commented. “For clients who have specific concerns—low risk, inflation protection, etc.—I research mutual funds with a track record and risk and return objectives that match my clients’ investment objectives. Most of those fall into a moderate or conservative asset allocation strategy that includes GTAA. Strategies include using asset classes for natural resources, TIPS, commodities and other real-return strategies in addition to global stock and bond asset classes. Plus stock ‘shorting’ strategies to reduce volatility and limit investment losses.”

Another advisor shared, “We have used a product that is a fund of funds product from our broker dealer. We have also used long/short funds, and managed futures funds in the mutual fund area for smaller clients. We used our back office, Lipper, and Morningstar to identify product and looked for non-correlating strategies.”

A third advisor commented that product decisions are “based on market outlook and a combination of quantitative and qualitative factors, such as phone calls and in person visits, asking people we trust [and] mining connections.”

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