If retirement portfolios were recipes, the most common ingredients would be annuities, bonds, cash and stocks. Add some real estate, most likely in the form of home equity, and you’ve got a financially diversified plate.
But is that approach truly diversified? Frank Muller, executive vice president and head of distribution for investment management firm Behringer (http://www.behringerinvestments.com) in Addison, Texas, disagrees. Muller makes the case that retirees’ portfolios should include an allocation to alternative investments; otherwise they are excessively constraining their investment options.
He defines alternatives in terms of what they’re not. Traditional investments are long-only stocks, bonds and cash. Assets outside those holdings can qualify as alternative investments, he says: “Anything that is one-dimensional investing, buying a stock, bond or cash, long-only would be traditional. I would argue that anything that is beyond that, whether it’s bi-directional, long-short, utilizes leverage or uses private equity or private debt strategies tends to be ‘alternative.’”
The Case for Alternatives
Muller believes that the demise of traditional defined benefit pension plans is a key reason retirees need alternatives. The majority of retirees manage their retirement incomes themselves, he says. They make investment allocation- and distribution decisions, effectively serving as their own defined benefit plan administrators. However, they—and often their advisors—lack an understanding of and experience with the full range of investments, including alternatives, which institutional-level administrators can access.
He conceptualizes a two-by-two investment grid to illustrate the problem. The horizontal boxes represent public and private; the vertical boxes represent debt and equity. Most individual investors limit themselves to the public boxes, he says, and consequently overlook opportunities. “When you constrain the investible universe only to public equity and public debt, therefore what you’re saying from an asset allocation perspective is that private equity and private debt don’t exist, that they have no material impact in the world’s financial ecosystem,” he says. “Yet, we know intuitively that that’s actually not true.”
The grid takes on more dimensions with the addition of directional investments—short and long/short strategies—plus the use of leverage.
The result is a much more complex investment palette that institutional investors and high net worth private investors draw upon to diversify their portfolios.
The challenge for advisors, he believes, is to understand these dimensions, explain them to clients, and then utilize the appropriate alternative investment products to support clients’ retirement income plans.
The Learning Process
Advisors certainly can learn how to work with alternatives; many already do so, says Muller. He points to the history of mutual funds as an example of how advice can evolve.
When advisors discussed mutual funds with clients 20 years ago, they described the funds in terms of broad objectives: growth funds, income funds, and so on.
As advisors gained experience with funds, the focus shifted to classifying the funds’ underlying securities by capitalization (small-, mid- and large-cap), style (growth, value or blended) and geography (EAFE, emerging markets, etc.). The same learning process and evolutionary approach is applicable to working with alternatives, he maintains.
Ultimately, adding alternatives to retirees’ portfolios is a decision on diversification, Muller says: “It is continuing to expand the notion of diversification. You either believe in it as a virtue or you do not. If you believe in it as a virtue, do you want to extend it to its natural and logical conclusion, which is encapsulating all of the world’s financial markets and then making those challenging decisions about how you proportionally allocate those dollars across all of those market conditions?”