Alternative investments have been called many things, but comparing them to succotash might win an award for creativity. The simile used by a speaker on Monday at the Seventh Annual Inside Alternatives investment conference in Denver sponsored by Financial Advisor and Private Wealth magazines was meant to convey the notion that alts are hard to define and, as such, require financial advisors to carefully consider how to allocate them in client portfolios.

“What is the nature of an alternative asset? Alternative assets are like succotash—it’s very complicated; it’s not an asset class, said Randy Zisler, managing partner at the real estate brokerage Zisler Capital LLC, who spoke on a panel on how alternatives can enhance portfolio allocation.

Succotash generally consists of corn and lima beans, but can include various other beans and vegetables. Not to beat the analogy to death, but alternatives consist of an array of products that can be utilized in client portfolios—provided the chef, or in this case the advisor, knows how to source the ingredients and blend them together.

Getting away from the food talk, alternative investments are about finding non-correlated assets that can improve a portfolio’s risk-adjusted performance.

Benjamin Deschaine, partner and portfolio manager at Balter Liquid Investments, said he has spent a large part of his career constructing alternative portfolios for some of the country’s wealthier families. “Why do we put alternatives into our clients’ portfolios?” he asked. “At the end of the day we’re looking for some sort of differentiating return stream for our clients.”

And liquidity is a prime influencing factor regarding how much to put into alternatives because you don’t want to be too illiquid, he added. “The liquid alternatives space is really coming into its own because the available funds are getting better and better. The question is how do you do that?”

One area Deschaine likes to focus on is less-efficient places in the market. “That’s where active management can really add value,” said.

In other words, don’t follow the herd by placing money in large funds that have attracted lots of cash but can often produce mediocre results as a result.

You have to be willing to take on opportunities that are smaller in nature,” Deschaine said. “It can be a little uncomfortable. But the reality is if you’re doing what everybody else is doing, you’ll end up with the same types of results.”

The liquid alternatives space allows you to construct more interesting portfolios for your clients in a way you couldn’t do five years ago, he added.

“From the standpoint of alternatives, it’s about how you communicate with your clients in terms of how you work them into their portfolios,” Deschaine said. “I think long/short equity investing in the small-cap space probably is a better way to approach small caps rather than just being long given their inherent volatility.”

To make a difference in a portfolio, Deschaine offered that alternatives should be somewhere in the area of 15 percent to 30 percent. “Some of you might think that’s huge, but it’s easier to get there than you might think,” he said
 
Anthony Caine, founder and chairman at LJM Funds Management, said choosing an arbitrary allocation amount isn’t the right way to go.

You don’t want it to be a case of the tail wagging the dog. Let your abilities to find high-quality alternatives dictate what the portfolio allocation should be,” he noted.     

Agreed, said Deschaine. “Putting alternatives into a portfolio for the sake of it is a mistake. Just don’t have a placeholder in there because you think you need something in this area. That’s a recipe for disaster.”

Caine said the challenge for advisors is finding alternatives that don’t have correlation with equities and fixed income in all scenarios because in extreme periods, such as 2008, they can become very correlated.

Along with finding the right products, he added, it’s equally important to find the right alternative investment managers. “Due diligence is critical,” he said. “We meet with a number of financial advisors, and very few do the proper due diligence.”

Caine gave a laundry list of items to consider and questions to ask when evaluating asset managers:

• Make sure the firm has sufficient infrastructure—do they have compliance officers, the right audit firm and the right cybersecurity in place?

• Does a firm have the proper risk systems in place? Does it have a chief risk officer who has autonomy from the portfolio management operations?

• Does the firm eat its own cooking? When a fund manager has a significant portion of their own money in their funds, they’re less inclined to take undue risk if a fund faces headwinds.

• Are there constraints in the strategy? If it’s a liquid strategy, is it truly liquid? Are they using exchange-traded products?

• Look at their track record after the first four criteria are met. “The number one area that causes a fund to fail doesn’t have to do with performance—it has to do with compliance violations,” Caine said.

Alternative investments can venture into interesting areas of the market—sometimes boldly. But Zisler cautioned that investors shouldn’t be too brazen about their assumptions on the ability of alternatives to unlock opportunities.

“Just because there is an inefficiency in the market doesn't mean you can systematically exploit it,” he said. “A lot of people talk about it, but they’re not convincing about how they’ll be able to achieve excess returns.”