The stock market’s roller-coaster of a ride following S&P’s downgrading of the U.S.’ credit rating on August 5 lent welcome exposure to a segment of the investment world that few life insurance and financial service professionals are well versed in: so-called “alternative investments.” Advisors would do well to take notice of them.
The diverse range of vehicles encompassed by the term include alternative mutual funds and exchange-traded funds that invest in hard assets and commodities, hedge funds, private equity and private real estate, collective trust funds, limited partnerships, managed futures, and other products. They are viewed by a growing number of asset managers as an indispensable component of a client’s portfolio.
The reason for this is because the investments can help increase returns while mitigating risk in volatile markets, in part because they don’t all rise or fall in value in sync with mainstay stocks and mutual funds.
That is music to the ears of advisors who are looking to diversify beyond U.S. equities, which have been battered in recent months by worsening news about the faltering economic recovery. The heightened interest in alternatives–products that were once the province of only the most wealthy, but that are now increasingly available to average investors through (most notably) mutual funds carrying low investment thresholds–is evident in recent statistics.
Alternative mutual fund assets grew 60% in 2010, ending the year at $201 billion, according to a new report from market research firm Cerulli Associates, Boston. While representing just 2.6% of total long-term mutual funds assets (up from 1.9% in 2009), alternatives grew at a much faster rate last year than other mutual funds, which rose only 16%.
As the Cerulli study shows, the severe recession of 2007-2009 led to a significant rise in product demand. In early 2010, 76% of asset managers polled by Cerulli said the financial crisis increased their interest in investment alternatives, a sentiment reflected in the inflow of mutual funds in 2009 ($31 billion) and 2010 ($51.9 billion).
The increasing popularity of alternative mutual funds is also mirrored in the level of product development. In 2010, the study notes, 65 new alternative mutual funds were launched. Prior to last year, the number of new funds never surpassed 50.
Also noteworthy: Much of the money being invested in mutual fund alternatives is going into commodities, which tend to be more attractive than traditional funds in times of uncertainty. Of the 65 funds launched in 2010, three of the top four most successful products are commodity funds.
Among them are Russell Commodity Strategies, PIMCO Commodity Plus Strategies, and JP Morgan Highbridge Dynamic Commodity Strategy. The most successful launch of 2010, the Russell Commodity Strategy Fund, secured $934 million for the year after debuting in June.
No doubt, this number is likely to grow substantially. Over the next 12 months, the study notes, more asset managers plan to devote a larger percentage of their product efforts to alternatives investments. Almost half (47%) polled in 2010 expect that between 50% and 74% of their product development in 2011 to be mutual fund alternatives (versus 7% in 2010). Most of the respondents plan to launch between two and three alternative products for the retail market over the next 12 months.
The report also finds that all managers are using (60%) or plan to use (40%) mutual funds to distribute their alternative investments to the retail marketplace. At least 40% of the managers surveyed have absolute return, multi-asset strategy, market-neutral and commodities in a mutual fund structure. A smaller number of firms incorporate hedge funds and private equity in their products.
While gaining in popularity, alternatives remain a small part of the investment universe: just 1.7% of total assets under management, according to Cindy Zarker, a director of Cerulli and the study’s author. The lion’s share of mutual fund assets remain in U.S. stock funds (42.2%). The balance is distributed among taxable bond funds, international stocks, balanced funds and municipal bond funds.
The miniscule percentage reflects, in part, alternatives’ recent entr?e to the marketplace for mass affluent investors. But, as Zarker points out, it also speaks to a significant investment in education that most advisors have yet to undertake. And without that education, they won’t be able to answer such basic questions as how, for example, a portfolio is to be structured with an alternative investment component; what other asset classes the alternatives would substitute for; or whether existing client funds or only new money should flow into the products.
Those financial professionals who commit themselves to moving up the alternative investments learning curve will reap their just rewards: portfolios that can withstand the shocks of highly volatile markets; happier and more loyal clients; and, not least, a significant competitive advantage over less skilled and less versatile investment advisors.