Assets in liquid alternative funds jumped from $32 billion in 2008 to $244 billion in 2013.

Hatteras published a white paper recently, “Defining Liquid Alternatives Investments,” that shows advisors how they can use alternative investments to diversify their clients’ portfolios.

Financial advisors are retail investors’ “best defense against themselves,” according to the paper, and alternatives provide a way for advisors to build “durable portfolios” that can withstand market shocks.

Following the dot-com crash, institutional investors recognized three benefits to using alts over traditional products: the ability to invest long and short, the use of leverage, and risk-return characteristics not available in traditional funds, according to the paper.

By investing long and short, portfolio managers can potentially profit not just from companies that are doing well but those that are struggling, too.

Leverage, or borrowed capital, allows managers to “amplify the impact of an investment through return enhancement.” Mangers can extends exposure by adding to the long side or shorten it by adding to the short side, according to the paper.

Hatteras noted, though, that clients need to understand that amplification works both ways — “while it can be used to enhance returns, it can also magnify losses should the underlying asset decline.”

Those benefits have been out of reach of retail investors, though, Hatteras wrote in the paper. Several limitations have kept alts out of small investors’ hands, namely investor qualifications and investment minimums. Cost, transparency, illiquidity and burdensome tax reporting have all prevented the flow of retail assets into alts as well.

Following the financial crisis, then the Madoff fraud case, investors couldn’t sell funds fast enough, according to the paper. “Suddenly, the interests of retail investors, institutional investors and high-net-worth clients were aligned; they all wanted benefits that alternative investments provided — diversification through noncorrelated investments and enhanced risk mitigation — with the ability to liquidate or shift their investment capital around at a moment’s notice.”

Consequently, assets in liquid alternative funds jumped from $32 billion in 2008 to $244 billion in 2013, according to Morningstar. Hatteras estimates that will continue, referring to research from Goldman Sachs that projected asset to grow to over $2 trillion by 2020, a 376% growth rate.

Investors’ desire for liquid alts is “only being strengthened” as equities reach all-time highs and the Fed hints at future rate increases, the paper wrote.

Part of the difficulty in talking about alts is defining them. Hatteras pointed out that Morningstar has 13 official alternatives categories, but also breaks out common “alts” like commodities or nontraditional bonds as separate categories. Hedge Fund Research, a hedge fund data and research firm, has five categories with 38 subcategories.

Another firm, Cliffwater, divides alts into “alpha-driven” and “beta-driven” categories. At Hatteras, alternatives include any strategy that “derives a meaningful component of its total return from nontraditional management techniques.”

Today advisors can choose from over 420 liquid alternative mutual funds, according to Hatteras. The paper broke down four main categories that these funds fall into.

Single-manager, single-strategy funds leverage the expertise of the manager, but are inherently less diversified. Single-strategy funds with multiple managers have broader expertise but must understand the impact of each strategy on the portfolio.

Multi-strategy, single-manager funds are typically offered by large firms with multiple teams who can monitor for overlapping positions. However, Hatteras wrote that these teams often have limited expertise in multiple alternative strategies, which may force investors to allocate additional funds to other strategies in order to get the exposure they’re looking for.

Finally, multi-strategy, multi-manager funds offer broad expertise and exposure while spreading the “idiosyncratic risk” of individual managers. They often come with an extra layer of fees, but Hatteras pointed out that “the investor is paying for the experience, guidance resources, risk management and due diligence of the investment manager.” Since mutual fund performance is reported net of fees, it’s up to the investor to determine if that’s worth the extra cost.

The most suitable strategy depends on what role the client wants alternatives to play in a portfolio, Hatteras wrote. Long-short debt, nontraditional bonds and funds that use multi-strategy/multi-manager structure are best for diversifying fixed income. Equity diversifiers to consider are long-short equity, market neutral, short bias and event-driven strategies. For overall portfolio diversification, options include multi-strategy, multi-manager , managed futures, commodity, REIT and currency strategies.

Check out Alts Are the Answer on ThinkAdvisor.