Risk on the Rise: Yield Chasers Rush Into Alternatives

One day in late January at the Investment Management Consultants Association’s annual New York conference, Lord Abbett market strategist Milton Ezrati got a big laugh from the audience of nearly 1,000 financial advisors when he recalled a recent visit to the Occupy Wall Street encampment in Zuccotti Park.

As he watched the swirl of placard-carrying protestors chanting in the park, Ezrati (left) realized the ideas that drove them to demonstrate were more complicated than he had originally imagined. This thought came to him, he said, when he saw one obviously savvy protestor bearing a sign that carried this punch line: “Stop Correlation.”

Over the course of 2011, advisors have watched in frustration as the value of investments ranging from large-cap U.S. stocks to emerging markets stocks to oil to gold have been rising and falling in tandem. This high degree of cross-asset correlation reduces portfolio diversification as it increases volatility.

“Given continued uncertainty in European and U.S. markets, investors expecting heightened market volatility in 2012 should expect correlation extremes to persist,” says Factor Advisors, a New York-based asset management firm, in a market report titled “2011: A Year of Correlation Extremes.”

Correlation Drives Advisors to Alternatives

Correlation, coupled with the U.S. bond market’s zero-yield environment, has driven advisors into riskier alternative investing. Indeed, since the Federal Reserve announced that it will keep its benchmark interest rate near zero until 2014, advisors often find themselves moving into higher risk territory due to client demand.

Bradley Teets, a certified financial planner in Punta Gorda, Fla., noted in a recent market commentary that retirees who previously earned 5% to 6% on conservative investments could expect income of about $5,000 or more annually for each $100,000 in savings.

“Now, if they earn 0.5% on savings, they have new income and cash flow of $500 to $600 annually if they are lucky and search out the best interest rates for their money,” Teets wrote. “Savers needing more income will be forced to bear more risk to chase yield from alternative investments.”

Traditionally, alternative investments such as hedge funds, derivatives, commodities, international currencies and managed futures have been held by institutional investors or high-net-worth individuals. But as high correlation persists, alternatives have been gaining in popularity with a wider range of investors and advisors.

Steve Enos, a principal and founder of San Francisco-based Cypress Wealth Advisors, says that more of his HNW clients are investing in alternatives such as master limited partnerships and real estate investment trusts to improve income.

Fed Policy Increases Willingness to Take on Risk

“If the Fed is going to keep rates low, you can’t keep your assets in a money market account, so you have to put it out where there’s some risk,” Enos said. “What clients are asking for is more return or more income, especially as bonds mature where they were getting 4%, 5% or 6 % yields and they’re now looking to reinvest at 2%, 3% or maybe 4%. It’s a tough quandary.”

Ideally, alternatives should dampen portfolio volatility when markets go down, but they should also retain upside potential when markets go up, according to Adam Patti, CEO of New York-based exchange traded fund firm IndexIQ.

While many investors would be happy to simply move their money into cash, it’s not such a great option these days because CDs and money market funds aren’t even keeping pace with inflation, said Patti, whose firm designs ETFs that replicate hedge funds.

“The better option is to have a good asset allocation strategy that includes diversification. The problem, of course, is that retail investors haven’t had access to education,” he said. “For example, many people still think hedge funds are designed to shoot the lights out with performance. But they’re called hedge funds because they’re designed to hedge, not produce 100% returns.”

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