Over the past several years, institutional investors increasingly have opted to allocate a portion of their portfolios to alternative investments as a way to smooth out market volatility and create potential gains in difficult markets.

In recent years the retail marketplace increasingly is following suit, as broadly-diversified asset allocation mutual funds are adding alternatives to the mix to help generate alpha and diversify away from the risks of the equity market.

This trend is a natural evolution in asset allocation strategies, which have grown vastly in significance since the Brinson, Beebower landmark study in 1986 of major pension plans showed that asset allocation greatly outweighed timing and security selection decisions in terms of portfolio performance.

In discussing investment strategies that seek to lessen portfolio risk, it is important to distinguish among different types and uses of derivatives. On the one hand, portfolio managers with more aggressive mandates than the type being discussed here can use derivatives such as equity futures contracts to add leverage to the portfolio, thereby increasing the beta, or market risk.

On the other hand, those same instruments can be used to manage market exposure and lower portfolio risk and volatility, in effect separating the beta of the market from the alpha generated by active managers. In this scenario, portfolio managers whose core competency is in security selection can produce an “alpha engine” to deliver a return in excess of a benchmark, while hedging away the beta, or market risk, through derivatives that can insulate the portfolio against punishing market conditions such as we have experienced in the wake of the subprime crisis. MFS is among the growing number of mutual fund companies looking to meet the growing demand of clients for such risk-managed strategies, through the introduction last year of our MFS Diversified Target Return Fund.

It should also be noted that a strategy that relies on a derivative overlay to manage market risk requires careful management of counter-party risk, including regular review of a firm’s counter-parties, established counter-party limits, and limits on risk through posting of collateral for trades, among other measures.

While earlier generations of asset allocation models combined asset classes of low correlation to lessen portfolio volatility, the traditional asset classes that made up those models are still subject to the vagaries of the market. As the subprime-related credit crisis that began to unfold last year expanded, very few asset classes were immune.

For the growing number of investors entering retirement, this risk is particularly acute. Advisors are looking for ways to neutralize their clients’ portfolios from the risks of the markets, and a derivative overlay strategy can provide that dimension.

Recent research by MFS into the concerns of the affluent pre-retiree and retiree market and their advisors shows that inflation is among their key concerns. Traditionally equities have been viewed as the asset class most likely to provide returns that outpace inflation over the long term, and should be at the core of most investors’ portfolios. But market downturns such as the ones that began with the bursting of the bubbles in the tech sector in 2000 and the subprime market last year underscore the need for hedged equity strategies to reduce volatility and help performance in such markets.

Given these factors, we would expect to see the marketplace increasingly demanding investment products that will seek to provide investors with a return that provides a modest but comfortable cushion against inflation over time, but that do so with less volatility than traditional investment products through the use of a derivative overlay strategy to help smooth out the markets ups and downs.

James Jessee

President, MFS Fund Distributors, Inc.

Boston, Massachusetts