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3 Ways Alternatives Can Help Advisors Manage Investor Emotions

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What You Need to Know

  • Alternatives can support clients in staying the course and offer them protection in bad times.

In the last few years, many alternatives have lagged broad stock markets, but recent market movement suggests a favorable shift.

For the year ending mid-May 2022, the rolling, three-month, annualized daily volatility of the S&P 500 has nearly doubled — from over 13% to over 25%. Returns for the S&P 500 were down over 18% and the AGG was down over 9.5%.

Meanwhile, many private investments fared much better, and the Wilshire’s Liquid Alternative Global Macro Index, a popular index in the liquid alternative space, was up 5.35% for the quarter.

Warren Buffet said, “Be fearful when others are greedy and greedy when others are fearful.” It’s hard to avoid letting emotions get the best of us when it comes to investing, which is why the market often follows investor whims.

Morningstar’s 2021 “Mind the Gap” study found that on average over the 10 years ending Dec. 31, 2020, investors realized 1.7% less than the funds their investments generated over the same span. Had those investors bought and held, they would have improved their return by one-sixth.

Alternatives offer important advantages in a portfolio. They have the potential to generate alpha; returns that are independent of the market; and they exhibit lower volatility. Perhaps their greatest advantage is their ability to help investors manage emotions.

An allocation to alternatives can help investors stay the course — like the “mother” of the investment portfolio. Here’s why alternatives are a lot like our moms:

Alternatives protect us from ourselves. Illiquid alternative investments create a barrier to sale, forcing investors to hold when they might otherwise sell.

Take real estate for example, which is largely considered one of greatest wealth-creation investments out there. One could argue that stocks historically outperform the underlying asset and yes, leverage plays an important role with regard to end results.

But the nature of real estate is such that investors are forced to make ­decisions counter to their rote ­behavioral instincts and hold through difficult ­periods. If there are barriers to sale, investors are less likely to look for the exits.

Alternatives provide a rosy view. Most illiquid alternative investments present lower volatility, so they feel safer. According to Hamilton Lane research, when looking at “­de-smoothed” ­volatility, private equity has a similar risk level to the public markets.

Though private equity typically outperforms at these risk levels, the behavioral advantage lies in the investors’ experience with private investments because of how infrequently they are priced. Investors do not experience the underlying volatility, and thus, their perception is that private equity is less risky than the public markets.

Simply holding private investments can resassure investors, in some cases.

Alternatives are the rock of the portfolio. When mothers tell their children that everything is going to be ok, it makes everything a little better. Alternatives offer the same reassurance.

Two low-correlating assets with high volatility can result in a lower combined volatility than either of the two assets on a standalone basis. Investors can look to the alternatives in their portfolio to see that things are not all bad, even in the worst of times.

We can see this now: In Q1 2022, many managed future funds were the bright spot in portfolios. The SG Trend Index, a popular index many manage futures managers use as a benchmark, was up 17.68%, compared to the return of a 60/40 portfolio being down about 5.6%.

Using alternatives in a portfolio is an important diversification strategy, but this has a number of behavioral advantages too. Like moms, alternatives can offer protection and comfort during bad times — which is when we all need our moms the most.

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Josh Vail, CAIA, is managing director of Hamilton Lane.