Alternative Investments – Testing the Waters

By: Brian Perlman

Our research with financial advisors suggests that the current paradigm for mutual fund investing, one that involves a portfolio mixture of equities and fixed investments has been challenged in the current economic climate:

  • With yields as low as they are, the fixed portion of the portfolio has virtually become a substitute for cash and advisors are reluctant to use it.
  • Furthermore, most experts feel that interest rates are going up exposing bond mutual funds to loss in NAV.
  • Yet at the same time, clients still have some risk aversion driven by lingering concerns from the financial crisis. This concern means that portfolio preservation and downside protection are still important, but there are few conventional ways to achieve it.
  • Some advisors use high yield bond and equity income investments as a substitute for safer debt instruments, leaving clients far more exposed to risk than they should be.
  • At the same time, many express concern that markets are reaching a top and that Fed easing and continued low oil prices will affect the stock market in the months to come.

One option in this climate is to use alternative investments that offer a smooth ride through hedging strategies and assets uncorrelated with equities and traditional bond products.  Investors get access to return that minimizes downside exposure.   However, there are three key challenges to these investments:

  • The 2008 collapse was so broad and deep that non-correlated risk proved to be ineffective as a protection against loss. Many advisors remember this.
  • Until recently, the market has been so strong that advisors who hedged their strategies to protect clients against loss, suffered portfolio performance that has not matched the indexes.
  • Clients, and even some advisors, have a lack of understanding of a number of the alternative instruments, exacerbating some skepticism of these products.

Nonetheless, these products may have a role that can be driven by understanding the clients’ goals and risk tolerance.  Alternative investments have a place with funds held for moderate timeframe financial objectives among clients who have some risk aversion.  The products make less sense for those holding them for the long run because they provide a drag on return in a portfolio held for a full market cycle.

These products also provide the opportunity for advisors to enhance the role they play by offering a wider range of options and enhancing diversification.  Some of these options such as REITs, high yield bond funds, preferred stock, and private equity have appeal to both clients and advisors. 

In a sense, alternative investments can play an analogous role to catastrophic health insurance – to protect people from a loss they cannot tolerate who subsequently sell low and turn paper losses into real ones.   According to the Investment Company Institute, the average holding period for mutual funds is seven years, far shorter than a full market cycle, and perhaps dampening fluctuation with alternative investments can increase the holding period.  Our research suggests that there is much to be gained by improving client behavior, over and above actual investment return.    

In our research, the biggest issue we see with the proper use of alternative investments is the lack of a systematic approach to determining their suitability.  These products are often recommended based on advisor preference and client interest rather than on the use of a financial planning paradigm as to when they make sense. 

The other issue is clients’ lack of understanding of the role that alternative investments play.  Clients have expectations that equity alternative investments will do as well as other equity investments.  If they had chosen to lower risk by using bonds instead for a piece of portfolio, they would not have the same expectations that this mixed portfolio would do as well as a pure equity in an up market.    

Given these opportunities and challenges, the opportunity exists for investment companies to get in the door with alternative investments by using financial planning and tools, rather than just putting new products in the marketplace.  Advisors sorely need a way to determine who  is appropriate for these products based on new measures of risk tolerance that determine how much of a loss clients can stomach before they make foolish decisions to sell low.  These tools can then be matched to proper product usage that sets a threshold for maximum loss at a 90% or 95% level of certainty.  The advisor can pick a portfolio that maximizes gain by setting loss parameters near a client limit.  Alternative investments can be a way to achieve these goals effectively.

Careers Greenwald & Associates