Amidst sharp volatility following a summer of financial crisis in Europe and fears of a double-dip recession in the U.S., advisors are increasingly turning to alternative investments to help shore up clients' portfolios.

A new survey finds that 68% of financial advisors have boosted their use of alternatives since the Crash of 2008, with 22% saying their use has "increased substantially" in the last five years.

Moreover, 67% of advisors say their alternatives allocation will continue to rise (with 11.1% saying it will "increase substantially"), according to the survey of 500 financial advisors by Jefferson National released in September. And more to the point, 61.5% believe that alternatives will be an even more important part of portfolios than traditional assets.

Not surprisingly, they aren't getting much argument from the alternatives experts, even as those experts acknowledge that alternatives are not a panacea for bear markets.

Of the myriad hedge fund strategies available, only global macro and managed futures were universally proclaimed to have performed well, profiting and protecting clients' wealth in the ugly days of July and August. "Anybody trying to do active management was punished," says Adam Taback, president of alternative strategies at Wells Fargo. August saw hedge funds posting their biggest monthly declines since May 2010, as the HFRI Fund Weighted Composite Index shed 2.3%. That knocked the year-to-date performance for the broad-based composite index to a loss of -1.2%.

Yet the experts say alternatives, long the province of the highest-net- worth individuals and deep-pocketed institutions, should be in every investor's portfolio. And in larger slugs than the 10% to 15% recommended for many years. Many throw around figures like 20% to 30% of a portfolio; some say as high as 40%. The good news is these strategies have been going through a process of democratization recently. Fees are coming down, and some strategies are becoming available to retail clients via mutual funds. So more investors can now buy alternatives. But should they?

It's the Correlation, Stupid

The experts all tout alternatives' relatively low correlation to traditional assets, including the stocks and bonds that constitute the heart of most portfolios. For decades, modern portfolio theory dictated diversification to cut volatility and balance risk with returns. And a diversified portfolio meant domestic equities, in large-, mid- and small-caps, as well as overseas stocks from developed and emerging economies, fixed income and some real estate.

The idea being if one of those components stumbled, the others would take up the slack. But over the last five years, these traditional asset classes have seen their correlation to the S&P 500, the core of most portfolios, go up, meaning if one stumbled, they all stumbled. For example, small- and mid-cap U.S. stocks have correlations to the S&P 500 north of 90%.

Even for international stocks, in both the developed and emerging markets as well as real estate, that number is higher than 75%. With the exception of fixed income, the traditional portfolio components are nearly perfectly correlated.

Yet over the same five-year period, managed futures, an alternative strategy that follows market trends, had a negative correlation (-6%) to the S&P 500. (See chart.) This trend of increasing correlation in traditional assets is especially marked in times of increased market volatility, like the 2008 credit crisis and the recent market swoons, according to Sam Aspinwall, alternatives expert and half of a financial advisory team at Raymond James specializing in executives. Until this January, when he and his partner Scott Warnock started their advisory business, they were strategists in the Raymond James Wealth Solutions/Alternative Investments Group.

Aspinwall notes that alternative strategies include nontraditional asset classes like currencies and commodities, as well as different methods of playing in traditional asset classes, like long/short and arbitrage strategies.

He concludes that retail clients must change with the times, take a page from institutional investors' playbook and use alternatives. "Back in the 1990s and before that, holding traditional asset classes was the way people attacked diversification. But today there are higher correlations between countries and traditional asset classes, and clients have to find ways to get more noncorrelated exposure," he said.

Higher correlations between markets are not just making investors' portfolios look less diversified. Higher correlations within a given market, such as the S&P 500, prevented a lot of managers, including those operating in the alternative space, from adding value in the recent market turmoil, according to Michael Crook, head of portfolio advisory at UBS' Wealth Management Americas Group. He notes that between 1980 and 2007, the average intramarket correlation for U.S. large-cap stocks tended to be in the range of 0.2 to 0.5. Since the financial crisis began in 2007, that number has been above 0.6, usually in the range of 0.7 to 0.8. That means it's very difficult for managers to add value by picking one stock over another within the S&P 500.

Intriguingly, this isn't just bad news for traditional long-only equity managers. Managers in the alternative equity long-short strategy have a difficult time as well. "Your shorts are supposed to behave in rational ways, but when markets are difficult, they get irrational as well. Stocks that are down might not move much, and your longs might get hammered in that environment," explains David Bailin, global head of managed investments at Citi Private Bank.

He adds that the ratios that long-short managers rely on, such as buying an energy ETF and holding a basket of energy shorts, stopped working. "Those relationships broke apart." The only surprising thing in August, he continues, was how many hedge fund firms that had strong convictions about certain trades did not let go of those convictions when the markets turned against them. "It cost them a lot of money," he notes.

Markets are betting this tricky state of affairs won't end soon. UBS' Crook says that the implied correlation for the next two years, according to the futures market, is 0.8. "It's very unusual for markets to be expecting securities to trade in tandem like they have for the last two-and-a-half years. And typically after a crisis, like the Lehman bankruptcy, correlations go down," he observes. But he adds, "We never got the normalization we usually see."

So the answer, he says, is to get exposure to alternative strategies-and not just for the sake of diversification. "If intraday market equity correlation is higher, that means overall volatility will be higher. You can draw similar conclusions across many markets, so the diversification you get from moving into alternatives is important for reducing volatility, but also from a return perspective," he says. "We currently have low expectations for managers in terms of adding value."

What Works, What Doesn't

The global macro strategy is one that's gaining fans because a good manager can add a lot of alpha. It is difficult to make generalizations about global macro because it is not so much a strategy as a grouping of managers who have no common strategy underlying what they're doing.

Some managers operate in multiple markets, including equities, fixed income, currencies and futures, around the world but others do not.

Each takes an investment view on a grand scale, looking around the world for opportunities to profit from broad trends, such as those affecting interest rates, government policies and politics.

The classic example of global macro investing is when George Soros made a fortune selling the British pound in 1992, betting that the UK government would have to devalue the currency.

UBS' Crook is willing to pay top dollar for good global macro managers not just because of their alpha and the fact that they were among the only ones to acquit themselves well this summer. "High-quality global macro managers are hard to find, but always worth pursuing because we have yet to see someone operate successfully within a mutual fund wrapper," he says. That's because the managers often have a high degree of discretion to pop in and out of positions, which can mean high portfolio turnover.

These qualities do not blend with the constraints of a mutual fund, which requires daily liquidity as well as transparency. While high turnover is not verboten in mutual funds, the tax consequences won't make a manager popular.

Other strategies that don't work well in the mutual fund format include those that require extensive short-selling or those that invest in extremely illiquid securities such as distressed investing. Regulators sharply limit the former, and daily liquidity requirements make the latter unpractical.

But strategies considered "plain vanilla" in the hedge fund world, such as equity long-short and merger arbitrage can work in a mutual fund. The strategies that tend to succeed have low alpha. That is, less of the performance is up to an individual manager's abilities. One example is AQR Capital Management, a large hedge fund firm with a strong following, which operates mutual fund versions of several of its strategies. They include momentum and a managed futures strategy.

Which brings us to the other end of the style spectrum: managed futures. It's a strategy practiced by managers known as CTAs, commodity trading advisors, which systematically, often quantitatively, follows trends. It can be profitable whether markets are going up or down, so long as there is a clear trend to follow. However, when markets are choppy, managed futures can get whipsawed. That means by the time the manager's models have identified a trend and the manager has taken a position, the trend can reverse and they lose money; when they take the opposite position, the market has shifted again, and they lose again.

As it happens, managed futures did well this summer despite all the volatility because many managers followed the same trades that made money for the global macro managers.

Taback of Wells Fargo explains that these trades were largely in the currency markets, which weren't as volatile as the broader markets. These trades worked "mainly because monetary policy hasn't been changing that much. It has been pretty predictable," he says.

In terms of cost, managed futures are a relative bargain, at least partly because they can sit well in a mutual fund wrapper. Warnock of Raymond James notes that he's seen the cost of managed futures products fall by more than half from 10 years ago. (He recalls some management fees as high as 4%.)

Some alternatives are becoming client-friendly in other ways too. A decade ago a fund of hedge funds would not have to give advisors and clients the names of the managers in the fund. "Today there's much more transparency in understanding who the managers are and what techniques they're using, what the structure is, what the holdings are, and so on," says Warnock.

So what didn't work? Some experts admit strategies they thought would zig ended up zagging. Others note that even with losses in some strategies, sticking to a plan is key.

"What we thought would work hasn't been working," admits Crook of UBS, who says that at the start of the year, most forecasters thought the recovery had taken hold, so strategies relying on corporate activity, like M&A event-driven strategies, would thrive. But the uncertainty created out of the debate in Washington over the debt ceiling as well as worries about Europe slowed all activity down. "These funds have not done poorly, but if there's no corporate activity, there's nothing for them to do. It's a group with high expectations at the start of the year, and we've not gotten there yet," he says.

Many hedge funds have not seen much success recently because most strategies were predicated on risk aversion going down, "essentially markets performing normally," notes Crook. That would mean having some differentiation in returns among securities, which climbing correlation levels refute. "If every equity in your portfolio does the same thing it's a difficult alpha environment."

Although there were relatively few winners in the hedge fund world, several glass-is-half-full Wall Streeters say that managers did a good job of diversifying investors' portfolios. Taback says equity long-short managers he follows were flat to down 4% to 5% in August, effectively lowering the volatility of portfolios for the month. But he says they disappointed in capturing returns when markets swung back. Bailin praises the hedge funds for coming back from 2008's losses and posting profits relatively quickly, reassuring clients. "Our client base is very preservation-of-wealth-oriented, not only profit-oriented," he observes.

Education, Education, Education

Taback and other Wall Street alternatives gurus report that while clients may not be stoic about the losses, many are resigned rather than panicked. The key, many say, has been education. Making sure clients understand what a manager's strategy is and what the outcome should be in a given market environment is crucial.

A good example is in understanding the difference in alternative strategies and the use of substitutes for equity long-only strategies, such as equity long-short hedge funds, or many of the mutual funds using alternative strategies. Taback says substitutes give portfolios equity exposure, but with a hedge to reduce volatility.

Meanwhile, alternatives should be thought of as a complementary strategy to the equity portion of the portfolio, another asset class meant to diversify the portfolio away from equity and fixed income. "The most important thing they can do is understand the difference and look for diversifiers like multi-strategy funds, which can come in the form of a fund of funds, global macro or managed futures-these are another asset class altogether," Taback says. "These work in concert with the rest of the portfolio, not as a substitute for an asset class."

Taback adds that in the current environment with loads of volatility, being 100% long equity may be more volatile than a client wants and alternative mutual funds or long-short equity hedge funds can give the client a good hedge on those and take some of the volatility out. "There's a space for both strategies and how you use them is not interchangeable."

Michael McGrath, head of alternatives at Morgan Stanley Smith Barney, says that if clients are nervous, advisors should discuss their alternatives investments in three steps. First, how are the managers performing versus their peers? If the performance is in line with the advisor's expectations, and hopefully better than their peer group, so far, so good. The second question is whether the market environment is one in which the client wants to add money to the strategy. If the manager is a momentum trader, will the market environment for the next year be a good one for momentum trades? Or would it be a good idea to switch to another category, such as long-short? The third step is asking what the client wants to do with his or her portfolio. If the client is nervous, and fully invested, and if the portfolio is performing in line with expectations, ask if the client wants to stick with it, or try to find a less volatile portfolio. If the client wants to rebalance and reallocate, talk about which lower volatility strategies to use.

"As a general rule, it's good policy for the financial advisor and the client to review where they are to see if it still makes sense and is in line with their goals. If the goals change or risk tolerance changes, then we'd look as product managers to make sure the solutions we offer the client are good choices," McGrath says. "You totally revisit the plan not because of the volatility of the market, but because you want to make sure the client's head is still in the same place it was six months ago."

Other observers report a bit more unease. Rob Stein of Astor Asset Management runs a separately managed account strategy with $1.25 billion, and he works with 600 to 700 financial advisors. He says he has seen clients become increasingly fretful. "Everybody got mugged in 2008, so they're walking down the street and hearing footsteps and saying 'I'm not letting that happen to me again.' So they're shooting first," he says. "They used to feel you could hide in the alternative space, but have now realized, 'Oh, you can lose money there too.'"

He agrees that advisors should tell clients to stay the course through losses, but admits it's not easy. "The toughest thing to do is to stay set when Rome is burning and you're down 6%, but the parameter is down 10% and you're sticking it out. The worst mistakes are made by people who exited or deviated from a strategy that wasn't proven not to be working."

What To Do Now

For all the talk about what didn't work, the alternatives watchers still advise clients to start with a diversified portfolio of alternative strategies, and not trying to time the market. Within that framework, there are still favorites, including managed futures, relative value strategies and long-short equity.

In relative value strategies, mangers take advantage of price discrepancies between two similar securities. When volatility is low, the profitability of a plain-vanilla convertible arbitrage trade, for example, is low. When volatility is high, the profitability of those trades rises. However, that action means that the managers are actually losing money because the trades they're currently holding, as they get more profitable, are losing money, because they're already in it.

Taback of Wells likes private equity, despite the fact that it's difficult to get a read on results because the illiquid nature of the securities means those funds report less frequently. He notes that it's a good way to get into some of the growth in the emerging markets. "China might be growing at a 10% rate, but long-only equity funds have had a hard time capturing that. But the private-only market has an excellent opportunity to join in with small firms as they get bigger and participate in that growth. The give-up is liquidity-a major give-up for retail investors-but the opportunity side is good."

He believes it will turn out to have been among the best opportunities for investors in emerging economies. "Now's what we call a 'vintage year'-a year you invest in Asian or emerging-market economies: Brazil, China, or Indonesia."

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