It’s one thing to add alternative investments to client portfolios, but it’s another thing to understand the different types of alternative strategies and products, how they’re designed to work in a portfolio, and how they can best address a client’s fears and expectations.

The topic was conversation fodder at a panel discussion today at the Fifth Annual Innovative Alternative Investment Strategies conference in Denver, which is hosted by Financial Advisor and Private Wealth magazines and has more than 700 attendees.

“The simplest way to explain alternatives to clients is to say we’re trying to find alternative sources of returns,” said Cleo Chang, chief investment officer at Wilshire Funds Management, the global investment management business unit of Santa Monica, Calif.-based Wilshire Associates.

“When we communicate alternative investing across the board regardless of whether it’s high-net-worth, mass affluent or institutional investors, we like to approach it by asking what do you currently not like about how your portfolios are constructed, and what risk do you think the current portfolio isn’t properly addressing.”

For folks with a traditional 60-40 stocks-and-bonds portfolio, Chang will ask investors whether they’re more concerned about rising interest rates or about equity beta, or both.

“I think those are different issues and concerns that should be addressed differently,” she said.

“We believe there are ways to utilize alternative mutual funds to try to reduce interest rate exposure without adding on much more risk to the portfolio, and that can be achieved by some combination of relative value, global macro and event driven types of strategies,” Chang explained.

But if investors still have 2008 on their minds and are worried about equity drawdowns, she added, one way to provide an equity-like portfolio with less drawdown risk is with an equity long/short strategy that she said has 20% to 30% less beta than a long-only equity fund.

Into The Pool

Dan Roe, chief investment officer at Budros, Ruhlin & Roe Inc., a RIA in Columbus, Ohio, said his firm starts the alternatives conversation with clients with a broad definition of alternative investments by explaining to clients they’re not stocks, bonds or cash.

“That [the alternatives space] could include commodities and real estate for some people,” he said.

But then they mention that those two asset classes will come with equity-like volatility, and that his firm favors splitting them off from the alternative bucket.

“We want to make sure that clients understand we’re seeking an alternative source of returns from stocks and bonds,” Roe said. “That’s why the definition of alternatives becomes important.

“These are allocations and a combined strategy meant to be a buffer, to achieve positive returns, and in this environment achieve positive returns greater than bonds while having volatility more akin to a bond allocation than to the equity markets,” he continued.

Alternative investments can be either illiquid, private equity-type investments or more liquid ’40 Act mutual funds and exchange-traded funds.

“With private equity-type investments, you want to know what you’re getting in that illiquidity pool can’t be achieved in a liquid pool,” Roe said.

Education Is Key

Alternatives have a steeper learning curve than, say, long-only equities. And as more providers roll out liquid alternative funds, that means advisors interested in these products need to do much more due diligence.

“There are so many great strategies out there, but quite frankly our heads our spinning like the girl from ‘The Exorcist’ trying to keep up with all of the new strategies coming out,” said Thomas Meyer, president of Meyer Capital Group, a Marlton, N.J.-based RIA. “There’s so much to learn, and we want to learn before we educate our clients.”

He noted that from a demographic perspective, most advisors’ prime investable asset base rests with clients between the ages of 48 and 68. “And they only know one way to invest, and it’s the long way. I’m talking about the mass affluent who don’t really understand what those strategies are about.”

Hence, one of the constant themes during this panel discussion was the need for advisors to get up to speed on the various alternative strategies so that they can better educate their clients on how these types of investments can improve their portfolios.

For example, Chang said, there are 86 non-traditional bond funds tracked by Morningstar. Within that category, the Wilshire research team classifies 51 of those 86 funds as alternative-strategy, relative-value investment styles. They classify an additional 12 of those 86 funds as alternative strategies in the event-driven vein that aim to take advantage of corporate events.

“Imagine this spectrum of strategies that you can be doing just within that one Morningstar category,” Chang said, “and that’s not even going into the true alternatives like market neutral and bear fund categories.

“In today’s environment it’s really important for advisors to dedicate the resources to truly understand the space and properly advise their clients, or to find some kind of outsourced assistance to decode what exactly is out there that are lumped into categories we’re so comfortable using,” she added. “Easy classifications can sometimes be misleading.”

How To Allocate

Meyer said his firm started looking into liquid alternatives in 2006 and 2007 to try to lower the beta of client portfolios. Their high-net-worth investors were in traditional hedge funds, but Meyer said they were more concerned about lowering portfolio risk for the firm’s mass-affluent clients. The relatively few liquid offerings at that time were mainly in the long/short equity category, along with some managed futures funds and other strategies.

“What we’ve learned along the way is it doesn’t make sense to put just 5% of portfolio assets into alternatives,” Meyer said. “If you want to try to lower the beta in an effective way, then you should have at least 20% to 25% in alternatives.”

He added that his firm ramped up to that amount by 2008-2009, and it helped buffer client portfolios during the market crash. That said, alternatives weren’t—and aren’t—a silver bullet.

“Our clients suffered in 2008; they just suffered less, which is important and that’s what alternative investments are there for—to act as a shock absorber,” Meyer said. “They really helped our clients versus being exposed as long-only investors.”

So where should advisors pull money from to allocate to alternative investments?

“If you’re looking at a 10% to 20% [alternatives] allocation, you’ll probably have to pull from both stocks and bonds,” Roe said, adding it makes sense to do that in the current environment where both equities and fixed income are, on the whole, at high valuations.

If you’re creating alternative allocations by taking that money from the fixed-income side, Chang said, you want to focus on taking money from investments with long-durations and which have the biggest interest rate exposure. If you’re designing an alternative portfolio that’s intended to reduce equity beta risk, then it should be sourced from equities.

“In our experience, most users gravitate toward a diversified alternative portfolio meant to be sourced roughly equal from both equities and fixed income,” Chang said.