The market downturn of 2008 scared the bejesus out of the investing public and hammered home the point that risk management is paramount in an age of increasingly correlated asset classes. In turn, that helped elevate alternative investments from the somewhat exotic to the practically essential when it comes to portfolio diversification.

While there's no Websterian definition for alternative investments, the consensus view holds they should have a low correlation to equity and fixed income, as well as employ both long and short strategies. This includes hedge funds or hedge-style alternative strategies such as long-short, event driven, market-neutral, global macro, merger and convertible arbitrage, relative value, directional/tactical, managed futures, short bias and options strategies. Other strategies and investments might apply, depending on one's interpretation.

A survey released earlier this year by Morningstar Inc. and Barron's found the growing importance of alternatives among both institutions and financial advisors. Among the 669 advisors surveyed, 66% said they believe alternatives will be as important or more important than traditional investments over the next five years. That's up from 58% in 2009 and 52% in the prior year. Among surveyed institutions, that number rose to more than 70% from the low- to mid-60% range the previous two years.

Despite alternatives' growing popularity, many financial advisors are still trying to figure out how-and how much-to use them in client portfolios. "I get that question all of the time," says Nadia Papagiannis, Morningstar's alternative investments strategist.

Papagiannis finds most advisors allocate 10% or less to alternatives. "I'd say that's not enough to be meaningful. Meaningful is at least 20% in terms of impacting the risk-reward profile. But I understand the practical implications of introducing this to your clients and then putting 20% into alternatives."

Papagiannis adds that a good alternative investment needs two things: low correlation to traditional asset classes and the ability to generate positive returns. Generally speaking, alternative strategies aim to outperform traditional asset classes in bear markets and tend to underperform in bull markets. But proponents say alternatives can outperform in the long run over several market cycles.

Take managed futures, for example. Based on an index of managed futures programs tracked by Altegris Investments, managed futures significantly trumped the S&P 500 index in bear markets and tended to trail in bull markets during the period from July 2000 (when the managed futures index began) through year-end 2010. During this time frame, though, the index's annualized return of 8.53% smoked the 0.47% return on the S&P. The key was that managed futures provided a smoother ride-the index sported a standard deviation of 11.20% versus 16.32% for the S&P during that period.

Diversified Buckets
Among advisors who use alternatives for their clients, two major themes emerge: the need to protect against long-only volatility in a portfolio's equity bucket, and the need to find something other than fixed income to diversify that equity bucket.

"It's about risk-adjusted returns," says Thomas Meyer, CEO of the Meyer Capital Group in Marlton, N.J. "The majority of investors who come through our doors think they're diversified, but they're long only. It's modern portfolio theory, but let's talk postmodern portfolio theory. Things change, and you're not as diversified as you think when everything is so correlated."

His firm started using alternatives in 2002 to avoid the high fees, illiquidity and lack of transparency of traditional hedge funds. They're big fans of alternative strategies, which he differentiates from commonly held alternative assets such as REITs, metals and currencies. His client accounts contain as much as 30% in alternatives, and that can include the bond side.

Meyer likes bond managers with the ability to go to cash or to short fixed income, strategies he believes can help fixed-income investors hedge against the inevitable rise in U.S. interest rates. "That adds another dynamic to the portfolio," he says. Among the funds employing shorting strategies, Meyer likes the JPMorgan Strategic Income Opportunities and the Eaton Vance Global Macro Absolute Return funds. He likes the Iron Strategic Income Institutional fund for its ability to go to cash.

Another player in Meyer's alternatives arsenal is the Miller Convertible fund. "The beauty of convertibles is investors get to play the game with far less risk by getting equity-like returns in a hybrid bond."

Jerry Verseput, founding principal of Veripax Financial Management in El Dorado Hills, Calif., says he re-evaluated what he was doing after 2008. He cautions against letting one year of market activity dictate strategy going forward, but his research made it clear that traditional asset classes among equities have become increasingly correlated and that the likelihood of interest rate hikes make fixed income an unappealing diversifier.

Verseput says all of his client portfolios contain roughly 10% managed futures, which he likes for their low beta. He also uses energy master limited partnership funds such as the SteelPath MLP Select 40 or SteelPath MLP Income funds; the Collar Fund, which writes a call and buys a put around a long-stock position to cap both the upside and downside of a stock; and the Aston/Lake Partners LASSO Alternatives fund, a long-short fund.

For accredited clients, Verseput's top pick is the Amerifunds Secured Income Fund, which is a private placement fund comprising privately-held mortgage notes. "I view this as the financial equivalent of watching paint dry," he says, adding it has averaged 7% to 8% during the past five years with almost no wiggles. "It's boring, but I'm finding that most of my clients are much more receptive to boring investments than they used to be." Overall, Verseput says, he likes to have about 20% to 40% of a portfolio in something other than straight equities and bonds or bond funds.

'40 Act Funds
The Morningstar/Barron's study found that managed futures were the largest single alternative strategy used by advisors, and that should continue during the next five years. The survey also found that financial advisors use mainly liquid investments--including funds--for their alternative strategies.

According to Morningstar, funds employing alternative strategies have flooded the market in the past five or so years. As of the end of last year, Morningstar counted 450 alternative-style funds-203 mutual funds and 247 exchange-traded funds. In many cases, hedge fund managers decided to democratize their formerly exclusive strategies for wealthy investors by putting them into '40 Act funds.

"Because of the credit crisis, some of the best hedge funds managers--even those who made money during the crisis--lost assets," says Jon Sundt, president of Altegris Investments, a La Jolla, Calif.-based provider of alternative investment platforms for advisors that access top hedge fund managers, managed futures funds and other alternative investments. "So now some of them are saying 'Gee, maybe now I'll consider managing money on the mutual fund side.' We're finding when researching these 5,000 hedge funds that more of them are considering managing money on the '40 Act side. This is a new trend that's good news for advisors."

Sundt is also portfolio manager of the Altegris Managed Futures fund, which he says picks the best managers in the Altegris 40-a cap-weighted index of managed futures programs-and combines them into one fund where each of them manages a portion of the fund. "Historically, you'd have to invest with these managers individually," he says. "They all have high minimums. They're different shops that complement each other."

Sundt says alternative strategies can provide "crisis alpha" in turbulent markets. "Some strategies have done very well during periods of crisis," he says. "Managed futures, global macro and even long-short equity have demonstrated good long-term risk-adjusted performance--especially when you needed them to during long periods when the stock market had negative returns."

But alternative investments require a lot of homework on the part of advisors. "The advice I'd give to advisors is to look under the hood for the quality of the subadvisors who are actually managing the money," Sundt says. "It's really important to get best-of-breed talent."

The same goes for alternatives under the '40 Act umbrella. "Many advisors will go right to Morningstar to find a long-short fund to invest in," Meyer says. "Morningstar has done a good job, but there's a long way to go in this area. Some of those funds aren't true long-short funds, and on top of that, there isn't a lot of history. But this is what we get paid to do, to find these managers who have been managing these types of strategies and who wrapped up these strategies in '40 Act funds."