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Alternatives – Can You Look Under the Hood?

Dec 2017 by Caroline Rasmussen

Alternative investments are continuing to gain popularity among high-net-worth investors. According to a recent report by InvestmentNews, which surveyed almost 400 advisors, mostly in the independent channel, 83% of clients have expressed some level of interest in alternatives.

While investors are becoming more willing to explore new approaches and products generally, the key driver of this trend is the challenging go-forward investment landscape, which will make generating return significantly harder than it has been over past decades. Much has been written about historically rich equity valuations, crowded investment plays and the challenges that today’s low yields portend for fixed income, which we won’t recap here. But the upshot of all these factors is an increasing need for the intelligent incorporation of alternatives into client portfolios, both to increase return and to mitigate risk. And with the shift from suitability to fiduciary decision making, the ability to demonstrate a thoughtful portfolio construction process that provides clients with a reasonable chance of meeting their goals is no longer just desirable, but essential.

Despite this, many advisors continue to collect strategies, rather than construct allocations that are designed around outcomes. Diversifying across asset classes for the pure sake of doing so may not only fail to reduce risk but may actually increase it, while compromising on return. In a world where the classic 60/40 portfolio is forecasted to generate half of what it has over the past eight years with significantly more volatility1, advisors must learn to effectively use alternative investments, which offer structures and objectives that can complement traditional equities and fixed income.

For instance, a client conversation may conclude with an agreement to establish a 10% allocation to hedge funds in order to reduce overall portfolio volatility and risk. But what does this actually mean? Long/short equity, activist, managed futures, and distressed strategies, to name just a few, each behave very differently. Advisors must understand how to evaluate the credit, equity, interest rate, and other risk and return drivers involved in order to ensure that they are in fact implementing the desired adjustment to the client’s portfolio. Selling ETFs and establishing a long/short allocation, for example, may not have much effect in a factor beta sense if the hedge fund manager has a significant long bias and less robust hedging program. Moreover, even if an alternatives allocation offers zero or negative correlation to traditional markets, its diversifying potential relative to the existing portfolio may still be negligible as a result of sector, style or other concentration. Finally, strategy labels at the end of the day are like photos on a dating app – they may not be accurate. Advisors must have some ability to look under the hood of alternatives managers and assess if the reality matches the marketing and makes sense in the current environment for a given client.

Recognizing the need for more advisor education on alternatives, we recently partnered with the Chartered Alternative Investment Analyst (CAIA) Association to offer CAIA’s Fundamentals of Alternative Investments certificate program to our private member network. The Fundamentals program examines core concepts in alternative investing including mechanics, risk management and due diligence as well as how hedge funds, real assets, private equity, commodities and structured products fit within portfolios and can be expected to perform under different market conditions. We are committed to offering similar educational programs and resources going forward so as to better position advisors to use and discuss these increasingly relevant asset classes.

On average, the typical advisor in the InvestmentNews survey cited previously expects that alternatives allocations among their clients will rise from 9.8% to 13.8% over the next three years. To the extent this survey population is a fair proxy for the overall RIA universe, that 4% expansion represents about $150 billion in net flows to alternative investments among independent advisers. Participating in these flows will require fluency in alternative asset classes, and the ability to successfully communicate the value proposition of individual offerings and strategies to clients. As a frame of reference, two thirds of advisors in the survey indicated clients’ lack of knowledge is a key impediment to using alternatives – more than objections over illiquidity (55%) and fees (56%). In addition to representing “stickier” allocations, alternative investments also require specialized access, due diligence and monitoring – all conversations that can demonstrate how HNW advisors add value to client portfolios. Developing an expertise in portfolio construction using alternatives can be a major differentiator for an advisory practice and an important element in building more valuable client relationships.

In sum, understanding the role that various alternatives can play in a diversified portfolio is more critical today than it has ever been. Advisors who do so and deliver better advice as a result have an opportunity to meaningfully grow assets and distinguish themselves from the rest of the pack.

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(1) Can a 60/40 Portfolio Still Produce Solid Returns?, Financial Advisor IQ, July 5, 2017