To remain successful, we must stay ahead of the curve. Maintaining an edge with the affluent community means knowing how to discuss alternative investments as part of your clients’ overall asset allocation strategies. In all likelihood, if you do not discuss “alternatives” with your clients soon, some other advisor will–and assume the assets.

If you believe these investments are not the best fit for your clients, be sure to educate them on the “why not.” Otherwise, you may be opening yourself up to retention risk.

There are at least two major reasons behind the growing interest in alternative investments:

First, the bear market of 2000-2002 prompted a desire for portfolios that could weather down markets and produce more consistent returns.

Then, in 1997, Congress repealed an IRS rule and opened the door for traditional mutual funds to employ shorting strategies. According to Lipper, since the start of 2003, the number of mutual funds that utilize hedge fund strategies has more than doubled–to 49 (as of December 2006) from 21. In addition, Lipper reports that the amount of money going into dedicated long/short mutual funds has doubled in just one year. By the end of 2006, the category had attracted nearly $6.3 billion in net assets.

Unfortunately, along with this growth and greater access came more headlines. Given the stories about great performance returns in top endowments with large allocations to alternatives, discussing these types of investments with clients may make their portfolio return expectations overly optimistic. Alternatively, with horror stories of fraud or bankruptcies at a few hedge fund firms, the mention of alternatives could strike fear in clients, keeping them from doing what is best for their long-term financial goals. In short, overreactions to sound-bites rather than to factual information may lead clients to act irrationally either by investing with unrealistic expectations or not investing at all.

An advisor’s key responsibility is helping clients overcome their emotions, allowing them to make the best decisions for their particular financial situations. In the case of alternatives, one of the biggest hurdles may be identifying and managing your clients’ fears and misconceptions. Another challenge is keeping clients from feeling ill-informed or overwhelmed when such arcane terms as “alpha,” “beta,” and “correlation” are being thrown around.

With that in mind, we’ll focus this month on telling the “story” of alternatives to the affluent client. The ultimate goal is to help your clients make more rational investment decisions that will help them achieve their financial objectives, while you retain and build on your AUM.

Since this is geared toward the affluent investor, the discussion about alternatives is based on the assumption that these investments are packaged in mutual funds.

Alternative Investments 101

At JPMorgan, we have found it useful to frame conversations with clients using a “funnel” approach starting with very broad concepts and working down to the specifics.

So, let’s start with a question that we hear often: What is an alternative investment? The easiest answer to this may be to say what it is not. It is not traditional stocks, bonds, or cash. Alternative products include hedge funds, private and public equity, real estate, distressed debt, venture capital, and energy and natural resources.

These non-traditional assets usually fall into two categories: strategies that are (1) a pure play (returns are derived from the specific asset) on “out of the ordinary” or “newer types” of asset classes, including commodities, real estate, and inflation-protected strategies; or (2) a more mixed play on everyday asset classes (such as equities). Thus, what makes it an alternative investment is not the underlying asset but the way the portfolio is constructed.

The Pure Play Option

Pure play or “out of the ordinary” assets are customarily used by investors as a way to enhance returns, but with the knowledge that they are taking on the additional specific risk of the asset. In plain English, these are lesser-known or non-traditional investments included in a portfolio with the understanding that the road to return may be rockier.

However, along that rocky road there may be a long-term benefit. A June 2006 study by Ibbotson Associates demonstrated that from 1970 to 2004, investors would have been better off adding commodities to a portfolio of stocks, bonds, and cash, despite the added volatility of commodity portfolios during that timeframe.

The term “portfolio octane” is often used when discussing alternative investments. Because of their volatility, your clients’ individual behaviors must be taken into account. Would wide swings cause them to act irrationally and exit before they should or possibly invest more when they should not? Ask clients if they are willing to accept greater volatility of returns for the potential “octane” addition.

The Mixed Play Option

On the other hand, since the 1997 repeal of the IRS rule that prohibited mutual funds from shorting, strategies involving a more mixed play on everyday asset classes have only recently become available to the affluent. The objective of these “hedge fund-like” mutual funds is usually to generate positive returns regardless of the market’s direction and gyrations.

This is called “absolute return,” because the return is not relative to a specific benchmark, such as the S&P 500. The focus is to make money in all types of markets–including when the “traditional” markets are down. That’s because absolute-return strategies seek to create value by eliminating the daily effects of market swings by using one or more strategies.

By and large, you can divide these many strategies into two groups: Return Enhancers and Diversifiers.

Return enhancers. These investments aim for outsized, upside returns, often through a number of fairly sophisticated investment strategies, including long/short equity, going long on stocks whose value is expected to increase and short-selling other stocks whose value is expected to decline or investing in derivatives (hybrid securities, such as crude oil futures, whose value is pegged to an underlying investment, such as crude oil prices).

Because these types of investments may equate to an extremely bumpy ride on the way to returns, your clients’ risk tolerance must be considered. Although the allocation to alternatives would not be a majority share of clients’ portfolios, would severe swings on their statements make them act irrationally?

Diversifiers. The objective of these investments is to help provide more protection against downside risks without losing the benefit of your clients’ exposure to equities. Diversifiers stress capital protection. The goal is to retain an equivalent return on an existing portfolio, but reduce volatility by adding investments that do not fluctuate in tandem with other core investments, such as a broad stock market index fund. Unlike return enhancers, these funds are not designed to be hot funds.

At JPMorgan Asset Management, we believe that including diversifiers as part of core portfolios is a must, especially, with the democratization of investing. Why? To quote Benjamin Graham, “The investor’s chief problem–and even his worse enemy–is likely to be himself.” The purpose of diversifiers is to make the ride smoother, with the hope of protecting your client from emotional whims that volatility tends to cause (i.e., irrational behavior).

Adding diversifiers to portfolios helps to preserve capital and provide a steady stream of returns that do not run parallel to the market cycles. The end result is that your clients benefit from having access to a more predictable capital base at any point in time. Diversifiers can help prevent you and your clients from suffering “statement shock” in down markets.

Market volatility is currently at historic lows. Are your clients getting too complacent with the current investment environment and/or their portfolios? Will they suffer severe statement shock as the markets’ volatility returns to “norm”? To minimize emotional reactions in the future, incorporating diversifiers into your clients’ asset allocation mix may make sense today.

However, it is essential to educate your clients and manage their expectations. Your clients must understand that, with diversifiers, they are not trying to beat the S&P 500 Index. Instead, they are trying to increase the likelihood of their success by decreasing the potential for portfolio gyrations. If their expectations are not managed correctly, there is a good chance that some investors may jump out of diversifiers when, for example, the stock market soars, and shift to a long-only, broad-based market fund in an effort to chase returns.

Know thy manager

Like any active strategy, it is critically important to know the reputation, investing style, and performance record of the portfolio manager. Conduct your due diligence; go back to the “4Ps” people, process, philosophy, and performance. The good news is that these hedge fund-like mutual funds are much more transparent than their hedge fund cousins.

With springtime nearing, take the time to reflect and renew. Are your clients’ portfolios providing them with the upside strength and downside protection they may need and demand in the future? If not, right now is the time to discuss the appropriateness of incorporating alternatives into your clients’ asset allocations.