Advocates of alternative investing often point to persistent market volatility as a good reason to hold more than just stocks, bonds and cash in a portfolio. These days, being long-only in the three basic asset classes means exposing a portfolio to the damaging effects of increasingly interdependent equity and fixed-income markets, which often rise and fall together in reaction to major market events. By combining traditional and alternative investments, investors may have the potential to profit within a variety of market environments.
Alternative investments—those outside of stocks, bonds and cash—typically have low correlation to traditional investments, meaning that their movements are generally unrelated to the movements of traditional investments. This low correlation may serve to “hedge” or help protect traditional portfolios during sideways or down markets. This is because asset classes that are not correlated generally do not move in tandem with each other—so when the market moves down, for instance, these asset classes may not fall as much as the market in general.
Alternative investments have been available for many years, and have been particularly popular with institutional investors (such as pensions and endowments), which have sought them out in an attempt to manage risk, improve diversification and provide more consistent returns. Today, a wider swath of the investing community is finding it easy to invest in alternatives in ways that provide the liquidity and low cost common among more traditional investments.
The annual AdvisorBenchmarking survey has been tracking advisors’ use of alternatives for several years. The most recent survey found that most (57%) registered investment advisors (RIAs) report they are attracted to alternatives for their ability to diversify a broader portfolio.
As indicated in the chart below, the majority (83%) of advisors use alternatives in their clients’ portfolio allocations, up from 72% in the prior survey. In both those surveys, about 20% of advisors reported having at least half their clients invested in alternatives.
Most RIAs surveyed, as shown in the chart to the left, advocate using alternatives either for many clients (42%) or for a select few clients (32%). Those results are consistent overall with the prior year.
This positive view of alternatives is echoed by a recent study from the consulting firm McKinsey & Co. It showed that assets under management for global alternatives reached record levels of $6.5 trillion at year-end 2011, having grown at a five-year rate more than seven times that of traditional asset classes. And that growth was despite a falloff in alternative assets under management during the worst of the financial crisis, 2008-2010.
When investing, it is important to have realistic expectations. While it is tempting to think alternatives will guarantee enhanced results, this is not necessarily the case. As with any investment, there is the potential for up and down days, months or even years. Additionally, there is no guarantee that diversifying a portfolio with alternatives will mitigate the risk of experiencing investment loss or result in a profit.
Here are three suggestions to improve basic knowledge and be ready to discuss alternative investments with clients.
1) Understand What Alts Are