It was only about five years ago that Morningstar created a broad “Alternative” asset class category. Since then, the addition of 14 sub-categories, including Long-Short Equity, Managed Futures and Multialternative, is a testament to the increasing popularity of investing in alternatives.

The Morningstar Multialternative category alone − which includes mutual funds that offer exposure to multiple non-traditional or hedge fund strategies − more than doubled from 31 funds in 2009 to 65 in 2012. Total net assets more than tripled from $5.6 billion to $17.4 billion during that time.[1]

An investment strategy once used primarily by institutional investors, alternatives have become a component in many individual investors’ portfolios. Yet while the asset class growth and increased demand catch the eye, these trends don’t answer the questions many of your clients may still be asking: What are alternatives? What are the potential benefits and risks of adding alternatives to a diversified portfolio? How can I incorporate alternatives into my portfolios?

Alternatives, defined

“Alternatives” may be a category best defined in terms of what it doesn’t contain, rather than what it does.  This asset class includes those investments typically found outside of traditional global equities and global fixed income.

At Russell, we group alternatives into:

  • liquid real assets (tangible assets like global real estate, global infrastructure and commodities),
  • alpha-driven investments (think non-traditional or hedge fund strategies) and
  • private market/illiquid investments (private real estate, natural resources like land and timber, private equity and private infrastructure).  

This categorization can be a helpful way to educate investors on the primary components of this asset class, and begin a conversation about the role they might play in a portfolio. A powerful tool to help manage risk and reduce volatility in a portfolio.

Many institutional investors have long touted the diversification benefits of investing in alternatives, which have historically had low correlations to both equities and fixed income. Increasingly, individual investors are following in their footsteps by using alternatives to help manage volatility and potentially improve the overall risk-return profile of the portfolio.

Many investors are adding alternatives to help manage different types of risks in their portfolios. While these risks will vary for each investor, we see two primary risks that many investors are trying to solve for in the current environment: where to get return in a low-yield bond market and how to diversify equity risk after a strong five-year run for equities.

The following table shows the 1-year returns, risk (as measured by standard deviation) and Sharpe ratios (a measure of risk-adjusted performance) for index proxies for U.S. equities, alternatives and bonds. Alternatives delivered returns between equities and bonds with the lowest risk during this time period.

While alternatives did not keep pace with strong equity markets and past performance is no guarantee of future returns, they certainly played the key role of diversifier and volatility reducer on a risk-adjusted basis.

Asset class index proxy

1-year Return

(as of 11/30/13)

1-year Risk

(as of 11/30/13)

Sharpe ratio

Alternatives: HFRX Equal Weighted Strategies Index

6.65%

2.46%

2.68

U.S. equity: Russell 3000® Index

31.71%

13.85%

2.29

Bonds: Barclays U.S. Aggregate Bond Index

-1.61%

3.93%

-0.42

Sharpe ratio = (Return – Risk-Free Rate)/Standard Deviation. Risk-free rate = 3-month Treasury-bill rate of .06 (as of 11/30/13). Alternatives category represented by the HFRX Equal-Weighted Strategies Index. U.S. Equity category represented by the Russell 3000® Index. Fixed Income category represented by the Barclays U.S. Aggregate Bond Index. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

More importantly, alternative strategies have historically weathered market downturns better than many other asset classes. Looking at the chart below, when equity markets were negative in 2000-2002, alternatives finished in positive territory. In 2008, both equities and alternatives were negative but alternatives were down about half as much as their equity counterparts.

Of course, investing in alternatives doesn’t come without risks and isn’t appropriate for every investor. Understanding the risks inherent in the alternatives market and whether they are appropriate for an investor’s situation and goals is critical. Each alternative strategy is subject to its own set of risks, some of which may include the ability of a borrower to repay its debts, the lack of marketability of an investment, the risk a party to an agreement won’t live up to the contractual obligations, and the use of leverage which can increase the gains and losses experienced with an investment. This list is certainly not exhaustive but begins to show the importance of strong due diligence.

Incorporating alternatives into a diversified portfolio

Alternative strategies should complement other components of a multi-asset portfolio, but there are a few specific methods of incorporation based on investors’ goals and needs. For example, clients looking to enhance return might consider replacing a portion of their fixed income allocation with a diversified basket of alternatives. Clients attempting to manage volatility might look at replacing a portion of their equity allocation with a diversified basket of alternatives.

The increasing use of alternatives has been accompanied by a proliferation of investment options. For investors, the exciting news is that more institutional-quality hedge fund managers — who traditionally ran private vehicles — are entering the mutual fund space. Choice is good, but advisors should evaluate alternative strategy managers on both the merit of their investment process and their operational processes. The bottom line

Investing in alternatives isn’t only for institutional investors. The availability of alternative mutual funds managed by institutional-quality managers is on the rise. As such, we have seen increased interest from advisors and investors in incorporating alternatives to diversify their portfolios, to help reduce the impact of the market volatility and to attempt to manage risk.

It’s likely that we won’t see this trend slow down anytime soon. But as always when investing, the devil is in the details so rigorous due diligence is necessary before making an investment selection for your clients.

Having a full picture of the firms offering alternative strategies — the principals, personnel, infrastructure, trading systems, investor base concentration, valuation techniques and pricing sources, regulatory materials, business continuity and more — is critical before investing. But you can see how adding alternatives to portfolios may help manage risk and reduce volatility while encouraging clients to stay invested.


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