Alternative Investments

Alternative Investments

The use of alternative investments continues to grow. According to Lipper, alternative mutual funds saw the biggest percentage growth of any fund group, with assets under management increasing 41% to $178.6 billion in 2013. A recent report by Goldman Sachs projects liquid alternatives are in the early stage of a growth trend that could produce $2 trillion in assets under management in the next 10 years. The number of funds have grown more rapidly than other fund categories–from 172 funds at the end of 2008 to 429 funds at the end of February, according to Morningstar.

Investors need to gain a better understanding of how alternative investments work, how they function within a portfolio, and where potential benefits and risks could occur.

Alternative investment strategies are a separate beast than the traditional methods of investing and traditional asset classes that most investors are familiar with. From divergent performance objectives, to the use of leverage, correlation to markets, liquidity requirements and fees, a fair amount about alternatives is different from traditional investments. Understandably, investors have many questions before they can decide whether to and how much of their portfolio to dedicate to alternative investments.

The task of educating investors about alternatives is falling largely on the shoulder of the advisory community. Well over half (60%) of the high-net-worth investors recently surveyed by MainStay Investments, indicated financial advisors as the top resource for alternative investment ideas. Trailing advisors was internet-based research (41%), research papers and reports (35%), and financial service companies (30%).

Historically, advisors have shied away from recommending alternative investment strategies because they are too difficult to explain. The conundrum they now face is that 70% of those advisors surveyed also acknowledge the need to use new portfolio strategies to manage volatility and still seek positive.

It’s important that advisors start to value the use of alternatives and find ways to bridge the information gap for investors. The good news is that investors have tipped their hands in terms of what they really want to know. According to the MainStay survey, clients want more information in the following areas:

• Explaining the risks associated with alternative investments (73%)
• Learning about how alternatives work (71%)
• Finding out who manages the investments (54%)
• Charting how alternatives affect returns (46%)

The world of alternative investments includes a range of hedge fund-like strategies that typically consist of publicly traded equity and fixed income investments, but are unconventionally managed using a variety of exposures (long, short, market neutral) and financial instruments. These strategies have gained acceptance in recent years, and have become more widely available to individual investors through vehicles such as mutual funds. However, questions still remain about the best ways to incorporate them into an asset allocation strategy.

We believe the true benefit of these strategies is how they perform in combination with an investor’s entire portfolio, including how they balance risk and return. However, because they are a disparate collection of strategies with different return streams that vary over time, it is difficult to bind them together as one asset class, comparable to fixed income or equities. While frequently discussed, there still is not a consensus among asset allocation practitioners on what the optimal asset allocation to these alternatives should be.

To help assess these alternative strategies, I believe investors should talk to their advisors about risk, including these three questions.

• What is the strategy’s directionality? One key risk measure to consider is directionality — the degree of exposure the strategy has to movements in the equity and fixed income markets. Whether a strategy has a high or a low degree of market exposure will impact how it’s used in a portfolio.
• How has the strategy performed in different market cycles? Another way to look at risk is to analyze a strategy’s performance during different economic regimes or market cycles — such as growth, recession and inflation, for example — paying particular attention to strategies that performed well when the equity markets overall were not.
• Has the strategy experienced extreme outcomes, and when? In addition to standard risk measures, it is also important to investigate a strategy’s historical pattern of major losses or extreme outcomes, as event risk can be high.

Once these risk measures are assessed, investors may have a better idea of which alternative strategies may be better used as complements or surrogates for traditional equity and fixed income allocations, and which may be used more tactically, based on varying economic circumstances related to growth and inflation.

SEC is stepping up its regulation of this category. The agency plans this summer to review whether some alternative mutual funds are complying with certain restrictions. It will begin by selectively examining funds at 25 investment companies and will decide whether to conduct a second phase of reviews after considering the results of the first reviews.

Jane Jarcho, associate director in the SEC’s examination program, says regulators will focus on some of the most common strategies attracting the most assets: nontraditional bond funds, long/short equity funds, multi-alternative funds and market-neutral funds. The commission is very interested in whether funds are adhering to liquidity, valuation and leverage restrictions imposed under the mutual-fund structure, including if the risks are being properly disclosed to investors, Ms. Jarcho says.

It is important to watch the underlying expense ratios of these funds as well. The average net expense ratio for U.S. open-end alternative mutual funds is 1.9%, but they could run as high as 4.6%.

Cliffwater LLC, an alternatives advisory firm, found in a 2013 study that returns for liquid alternatives on average trail private alternatives by about 1% annually. That discount varies according to the alternatives strategy, the type of liquid vehicle chosen and declines when market stress increases, the Los Angeles firm says. The study looked at 109 investment firms that manage both private and liquid offerings, including mutual funds, separately managed accounts and listed securities, among other investments.

Disclaimer

Asset allocation/diversification does not guarantee a profit or eliminate the risk of loss.

Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.

(Source: WSJ, MainStay, Brinker, Invesco, etc.)