It’s one thing to want to include alternative investments in a client’s portfolio, but it’s another thing to understand how to do it properly. “Financial advisors understand the why, but they’re trying to get a better idea about the how [to implement alternatives into portfolios],” said Mike Wood, director of alternative investments at Charles Schwab.

Wood spoke on a panel focused on asset allocation with alternatives at the second annual Innovative Alternative Investment Strategies conference in Denver this week that was hosted by Financial Advisor and Private Wealth magazines. But given the topic’s importance, it was part of the conversation on other panels during the conference, too.

Asset allocation is essentially a risk management service, and the desire to mitigate risk has sparked greater interest in using alternative investments, said Rick Lake, co-chairman and treasurer at Lake Partners.

He cited a Cerulli study that found that investors use alternatives to optimize risk-adjusted returns.

From a practical standpoint, the game plan can include using various alternative strategies such as long/short equity or long/short bonds, which can take advantage of market volatility in their respective asset classes.

Event-driven strategies are another viable option. “Events happen in the business world than can be sources of return,” Lake said. “One example is merger-arbitrage, which can offer returns that are different from the marketplace.”

Lake said advisors can construct alternative sleeves in a portfolio based on products with different liquidity characteristics––daily liquidity with ’40 Act funds; periodic liquidity via hedge funds; or illiquid assets such as private equity and farmland.

Advisors can also seek out diversifier products such as managed futures that can deliver low correlation to traditional assets.

But Lake highlighted some of the challenges of including alternatives into an overall portfolio. One of them is the proliferation of offerings in the alternative space, which can make product selection difficult.

Another challenge can be the varying performance within certain alternative investment vehicles. Lake presented a slide that showed the huge dispersion of risk/return performance among long/short equity mutual funds since the market top in October 2007.

“There’s a lot of potential for selection success and for selection error,” he said. “If you pick the wrong one, you don’t get diversification.”

And that’s why it pays to know how to better evaluate alternative investment opportunities. Kerry Jordan, marketing director and chief compliance officer at Chicago Capital Management, said aspects to consider when doing due diligence on an alternative product manager include the firm’s performance track record; how long the management team has worked together; and how the manager and his staff identify investments to put into their portfolio.

“That’s very important in terms of their ability to continue to generate consistent returns,” she said.

Jordan noted that style drift can be a problem for certain alternative managers Some hedge funds, she said, shift from their stated strategy when it fails to produce alpha as the markets change. “That can produce a mishmash of returns that generally aren’t representative of a dedicated style.”

Among the intangibles to look for, Jordan added, is the manager’s passion. “You want to have someone who’s truly consumed by the trading style that he’s doing and is dedicated to it,” she said.

Gabriel Burstein, head of investment strategy at Curian Capital, offered that alternatives shouldn't comprise more than 20 percent of a client’s overall portfolio.