December 7, 2012

Alternatives Myth-Busting: Can Alts Dampen Risk?

Roundtable with Aston Funds, Direxion, Salient managers argues that advisors can best manage volatility with alternative investments

More and more advisors are turning to alternative investments in this low-yield environment, yet for many the jury is still out over whether alts add too much risk to client portfolios.

In an attempt to answer the question of whether alternative investments can or can’t dampen risk, a group of three managers for Aston Funds, Direxion and Salient gathered Thursday in New York to do some alternatives myth-busting.

“Transparency, liquidity and cost–those are advisors’ biggest concerns,” said Edward Eglinsky, managing director of alternative investments at Direxion, adding that his firm considers alternatives to be anything that falls outside of the universe of long-only stocks, bonds and cash.

Using that definition, alternatives include long-short equity, REITs, currencies, hard assets and managed futures. To be sure, all of those investments have found their way into the portfolios that advisors manage. More than 75% of institutional investors in the United States consider alternative investments essential to a diversified portfolio, according to two separate recent surveys performed by Cogent Research and by Natixis Global Asset Management.

Look at those studies a bit closer, and it becomes even clearer why advisors are investing more in alternatives. The Natixis study found that 72% believe the common 60% stocks/40% bonds mix in portfolios is no longer an efficient way to achieve returns, and the Cogent study found that 78% use mutual funds to access alternative investments.

“Most people view alpha as the holy grail, but we think alternative beta is more interesting and widely available,” said Jeremy Radcliffe, co-founder and managing director with Salient Partners.

Radcliffe said preferring alpha over beta is a misplaced notion because alpha is a zero-sum game, and what was alpha 10 years ago simply isn’t anymore. Salient favors viewing alternatives in terms of achieving “risk parity” in a portfolio, Radcliffe said.

Rick Lake, portfolio manager with Aston and co-chairman and treasurer of Lake Partners, did some more myth-busting while speaking of “the challenges of being a traditional investor right now.” The biggest challenge for advisors is climbing the learning curve and figuring out how to integrate alternatives into asset allocation, he said.

But Lake urged advisors to take the time because understanding how alts operate is key. For example, he said, the dangerously casual use of the term “uncorrelated” suggests that investing in an alternative without understanding its risk profile can end up with zero yield in a positive environment.

Another myth-busting topic, commodities, had Egilinsky and Radcliffe agreeing that there are investor misperceptions about the risks. While long-only commodities may correlate with stocks, they are not as inflationary as stocks, they noted.

Turning to the subject of volatility, Radcliffe said that the traditional pre-2008 view was that a 60/40 portfolio would mean volatility of about 10%. But in the crash, he said, investors were shocked to find the volatility rise to 40% to 50%. Now, he said, Salient gauges a portfolio’s level of volatility and then targets it with instruments such as futures.

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Read Hedge Funds Badly Beaten by S&P 500 Performance at AdvisorOne.com.

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