2 Ways to Remove Alternatives’ Mystique for Clients

What You Need to Know

For clients who seldomly look at their portfolio and aren’t steeped in the markets, talk of change can be intimidating.
Alternative strategies fall into two camps: those that invest in assets that are harder for individuals to access and those that manage assets in a unique way to create a unique return stream.
By explaining a strategy’s role and the basics of its underlying investments, advisors remove the shroud of complexity.

The new year provides a natural opportunity for advisors to review portfolios with clients and discuss whether to add anything new to the allocation. For financial professionals, these conversations come naturally.

But for the end clients who rarely look at their portfolio and aren’t steeped in the markets, talk of change can be intimidating. This is particularly true when it comes to alternative investments. And honestly, the industry hasn’t exactly made itself inviting.

A negative headline about a sensational hedge fund manager is sometimes the only thing the average investor might hear about the asset class. And whoever named most strategies — long/short, event-driven, merger arbitrage — clearly wasn’t a marketer.

But dialogue with clients about alternatives doesn’t have to be confusing. In our own client conversations, we’ve found two ways to remove the mystique:

Get to the Core: What Do Alternatives Really Invest In?

Alternative strategies fall into two camps — those that invest in assets that are harder for individuals to gain access to (think real estate, private equity and private debt) and those that manage assets in a unique way to create a unique return stream.

For the former camp, these assets — while harder to access — are not so different from traditional assets. The investor still is doing one of just three things: owning, lending or exchanging a currency.

With real estate, for example, the investor is taking an ownership stake in the real asset. With private equity, they are buying an equity stake in a company … it is just taking place in a private market. Private debt, meanwhile, simply means lending to a private business. And gold, like cash, is seen as a store of value. Derivatives, meanwhile, are instruments that’s value is tied to one of these three assets.

The second camp of alternative strategies — those that manage assets in a unique way to create a unique return stream — are often more intimidating. This is a function of nomenclature. Take the event-driven fund as an example. The name may sound perplexing, but the strategy typically is just buying and selling stocks. It is just uniquely focusing on the opportunities that arise from a corporate event such as a bankruptcy, merger or restructuring.

Explaining Purpose Makes Alternatives Less Perplexing

While there are many alternative strategies to choose from, they typically play one of three roles: Enhancing return, reducing risk or diversifying the portfolio. Framing the purpose also helps make sense of the strategies.

The first category — return enhancers — is easiest to conceptualize. If an advisor and client believe they can get excess return from private equity, opportunistic long/short, or concentrated thematic investments, they may want to consider the opportunity.

The diversifier category includes alternatives with little correlation to equities. A few strategies that fall into this category include managed futures, market neutral and multicurrency funds. Their role should not be understated. Most asset classes are highly correlated to stocks, which has big implications during a downturn. For perspective: an equally weighted portfolio of two assets with like volatilities and a correlation of 0.7 would still exhibit 92% of the volatility of either asset in isolation. Strategies in this category seek to bring that portfolio volatility down.

The third category — risk reducers — reduce portfolio risk, but don’t overly sacrifice returns. The objective is different from diversifiers. In short, these strategies hold up during equity market downturns, but typically outperform more traditional downside risk mitigators over longer horizons. Examples include long/short equity, long/short credit and non-traditional bond funds.

By explaining a strategy’s role and the basics of its underlying investments, advisors remove the shroud of complexity surrounding alternatives. Clients may, or may not, decide the strategy is right for them. But they won’t balk at the initial conversation.