With future forecasts of stock and bond markets that aren’t forever bullish, many advisors have added or are looking into adding liquid alternatives to their client portfolios to increase returns, reduce volatility and/or diversify risk. The consensus advice from panelists at a Morningstar Investment Conference session addressing how these products can fit an investment portfolio is: Alternatives are good investments in many markets, however you have to be cautious, cost-wary, and be able to explain them to your clients, which isn’t always easy.

Morningstar Senior Analyst Jason Kephart began by defining this particularly broad asset class as skill-based strategies that don’t tend to rely on market data to get returns. Bob Boyda, head of capital markets and strategy for John Hancock investments, agreed, adding that liquid alts have beta, but they “just don’t have beta related to traditional bond/equity beta,” he said. He said they see these as alternative styles, like hedge funds and GTAAs, but also them as subsets of an asset trying to abstract pure alpha, such as long/short currency and long/short equity funds.

Catherine LeGraw, CFA and global asset allocation team member of Grantham Mayo Van Otterloo, noted her firm was “not particularly optimistic” in its outlook for stocks and bonds. “But you still need to invest in the portfolio, and many alts we look at still have positive expected returns.”

Some, such as global macro, long/short and relative value, despite their expense, still “have great value.”

Joel Dickson, global head of investment research and development at Vanguard, said they look at alternatives more within the portfolio and “overall diversification of a portfolio over time. If you can achieve these alt risk premiums in a way that diversifies traditional exposures, such as stock and bond beta, in essence you can think of expanding the opportunity set.”

Boyda added that if a manager is only thinking about the alpha stream, he needs to consider from where to fund it. He provided some negative correlation scenarios that may or may not work depending on the market. “There is skill in deployment for alts inside your portfolio,” he said.

LeGraw injected that GMO doesn’t “take much comfort in low correlations,” adding that her firm expects alts to have negative returns in a downward market scenario. “But we do love the diversification in valuation risk” that alts provide, she said. She added that alts have “shorter duration” than many stock/bond plays. For example, a merger/arbitrage has two companies going through a transaction that will close, or not, within six months. “While we don’t place that much store in negative correlations, we do like the fact that alternatives have less repricing.”

Dickson said they look at diversification a different way, in addition to alts lowering the volatility of a portfolio. “Even if strategies or approaches are highly correlated, there may be a dispersion in returns of different strategies, same expected returns with different outcomes across strategies, so it’s a return element rather than a volatility element.”

He added, “Alts aren’t table scraps. We’re talking about a portfolio construction exercise and alternative risk premiums. How does it fit with all the other strategies I have in my portfolio to give appropriate allocation that will add cost, risk tolerance, lever for returns. It’s not a bond substitute … Risk premium is a different discussion; it stands on its own.”

Boyda said, “These animals don’t march to normal behavior,” illustrating the difficulty in explaining alternatives to clients, such as manager skill, correlation coefficients, et cetera, can be uncomfortable because they aren’t the standard reasons. “It’s like being in outer space without any way to navigate …. You need to keep the client actively involved.”

He added that alpha engines, such as currency or absolute return funds or GTAAs, should be added to portfolios as long as they are acquired at reasonable fees and can be explained to the clients. “This is an area where we must raise allocations in our portfolios.”

Dickson cautioned that “if alts are used for return or volatility diversification, at some point there is a trade-off between diversification value and cost.” For example, a strategy may look attractive theoretically, but “when you actually implement the strategy return, roll, cost and downside risk, it might give you a different answer with real-world costs.”

Boyda and Dickson disagreed on using alts in target date funds. Dickson said they don’t use them because alts don’t provide enough needed information. Boyda said they do use alternatives in target-date funds because “it makes sense for diversification and return reasons. Yes, they are expensive, but there is hope on the horizon with a plethora of alt strategies showing up in the ETF space.”

Watching daily liquidity and keeping a lock on leverage of these products is essential, LeGraw said. Also, be careful of illiquid alts that have lock-up periods such as timber or private equity funds. The liquidity opportunity cost might be higher than the return on investment of the illiquid product.

Costs of alternatives and how they are priced and how to determine fees is tricky, panelists agreed. Kephart said that Morningstar believes there’s a lot of room to lower these fees, and some of the 1.5% to 2% fees aren’t justified. “We look at fees on peer category, which for long/short equity the average fee is 1.5%. That’s too high.”

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