During the crisis, the stock market dropped 55% and even diversified portfolios lost 32% on average. Some Ivy league schools, however, famously benefitted from heavy investments in alternatives, notably real estate and private equity funds, which fared better than stocks and bonds.
That experience by university endowments impressed Dave Wolf, an advisor at United Community Bank in Lawrence, Ga. (Invest Financial is the TPM for United Community.)
These days Wolf is increasingly turning to alternatives for his clients' portfolios, both as a way of reducing volatility as well as generating more income at a time of still record-low interest rates. "The traditional 60/40 model failed or underperformed in 2008," he says, adding, "Studies show that adding 20-30% alternatives to a portfolio gets you both a higher return and a better standard deviation."
Wolf is not alone. According to a new report by research firm Cerulli Associates, advisors are increasingly recommending alternative strategies to their clients, including retail clients, with 25% reporting that they have plans to increase their allocations to alternative mutual funds. Meanwhile, a second report by Barron's and Morningstar finds that only 4% of advisors are still saying in 2013 that they don't use alternatives in portfolios, down substantially from the 17% who were saying that back in 2008.
Meanwhile fully two-thirds of those advisors who do recommend alternative investments to clients told Cerulli researchers that they like alternative allocations of between 11% and 20%, while another 15% said they expect to be putting more than 20% of client assets in alternatives this year.
At Raymond James, Chris Butler, co-head of alternative investments, says the increased interest in alternatives among advisors has been dramatic. "In 2009, we had $500 million in alternative mutual fund assets," he says. "Today, it's $1.5 billion, and that's just advisor-directed. So that's a three-fold increase, and it doesn't include alternative allocations within firm-based models, which have also grown."
Raymond James currently has a guideline of a 20% maximum for the allocation of alternatives in a portfolio. Butler is quick to stress that this is not a hard-and-fast maximum, as advisors reach that kind of decision in consultation with the client, but he says it serves as a guide. (There is a harder line drawn on individual alternative investments, with Raymond James saying no one investment should exceed 3-5% of the total client portfolio.) Butler adds that the guideline on maximum alternative allocation is "now shifting gradually up" to the 25-30% range, which he noted would include "a number of different managers and strategies."
Butler says in years past there was the same 20% maximum guideline in place, but it has been "a lot harder to get to 20% of a portfolio, given the restriction of no more than 5% in a single investment."
Now, it's easier to do, he says, because of easier access via mutual funds. "We've also gone from just 15 approved alternative mutual funds in 2009 to 36 approved funds today."
Indeed, the demand driven largely by advisors, according to Butler for alternative investments at the retail and mass-affluent client level has produced an explosion in new alternative mutual fund offerings, as well as a wider range of investments in those funds.
In just the past year, 101 new alternative mutual funds were established. More are in the pipeline, too, with Cerulli reporting that 43% of asset managers interviewed said they are currently working to put together new funds.
Meanwhile, Morningstar, in its latest report on alternative mutual funds, notes that 15 alternative mutual funds now boast more than $100 million in assets and have advisors with track records of at least three years at one fund. An estimated $19.7 billion flowed into these funds over the past year alone, with much of that money reportedly coming out of equities.
There are currently 14 alternative mutual funds that have earned a five-star Morningstar rating, and another 43 boast four-star ratings. These funds offer clients access to investments in everything from managed futures to nontraditional bonds to market-neutral and long-short equity strategies, as well as "multi-alternative investments."
The creation of a competitive alternative mutual fund industry offering hedgefund-like options is a game changer for retail investors and their advisors.
Besides increasing the options for diversification beyond commodities or emerging markets, they bring alternative investing out of the rarefied realm of the "sophisticated investor," where high minimum investments and a lack of liquidity and transparency can pose insurmountable hurdles to participation.
With mutual funds, there is a relatively high degree of transparency, liquidity is not a problem, and costs are much lower running from a low expense ratio of 0.46 to a high of 3.75 making it possible for anyone with even a small nest egg to invest in alternatives.
"There have been major inflows into the nontraditional bond funds," reports Morningstar analyst Josh Charney. "Long-short equity funds too are doing well, and are now up to $40 billion and going strong."
Charney says he is not surprised that allocations to alternatives have been rising. There was a time when advisors would recommend putting 5% or perhaps as much as 10% in alternatives in a portfolio, but Charney says, "That is really not enough to move the needle," in terms of providing diversification for a traditional stocks-and-bonds portfolio. For those advisors who are going to raise the allocation to alternative investments significantly above that level, he says the key question to consider is this: "Does the investor understand the investment?"
Ryan Beal, an advisor at CME Federal Credit Union in Columbus, Ohio, agrees. He is putting 20-25% of portfolio assets of his clients into alternatives these days and says he may eventually get up to 40%, but he says he is careful to explain what he's doing along the way to each of his clients. (CUSO Financial is the TPM for CME.)
Beal says he doesn't try to confuse matters by asking his clients to choose between conservative, moderate or aggressive options. "I'm paid to give advice, so I'm the type of advisor who, after I've discussed goals and risk tolerance with my client, is going to say, 'Here's what I think you should do.' (Read more about Beal in our Producer Profile story.)
DIFFERENT PATHS TO THE SAME GOAL
There is more than one way to achieve this overall goal of non-correlation for your clients.
Philip Moses Jr., an advisor at First Federal Bank of Florida in Lake City, Fla., for example, is a fan of structured products.
While he likes the new selection of alternative mutual funds, with their daily liquidity and low minimum investments, he says structured products offer income and downside protection as well. (Raymond James is the TPM for First Federal.)
As an example, Moses cites buffered notes, digital barrier notes and equity-linked CDs. With a buffered note, usually offered by a large financial institution, the investor is protected against the first 10% of any fall in an index while providing 1.5 times any rise in that index at three-year maturity. He notes that such issues pose a credit risk, because the issuer could fail. But he considers that a low-probability risk.
A digital barrier note, he says, linked to some index like the S&P, has a trigger level. That is, the investor is protected on the down side against a 25% to 30% fall in the index (the trigger after which the investor does start to lose), while on the upside, he or she gets a 30% gain at the end of five years if the index is up at all over the period, plus all the upside beyond 30%.
Such certificates of deposit, which Moses notes are insured by the FDIC to $250,000, offer "dollar for dollar" any gain in the index at the CD's seven-year maturity date.
"Most of my clients are not informed about structured products like these," says Moses. "My suggestion to them is that they make a modest investment in them to educate themselves. Then over time, as they see how they work, they'll invest more."
So with all this money piling into alternatives, is there a risk that these investments will cease being alternatives? Will they start moving in lockstep with the broader markets and consequently start losing their non-correlating attractiveness?
Morningstar's Charney doesn't see that as a problem. "With a particular asset class, you can have a problem, for example like what happened in the early 2000s when REITs were added to the S&P, after which they became correlating assets with equities. Certainly niche strategies, like convertible bonds, could get swamped by too much investor attention. But I don't think that could happen to alternative strategies in general. They can handle a lot of money flowing in."
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