The allure of alternative investments -- potential gains that are uncorrelated with stock and bond price movements -- is not without risks that investors need to be aware of, a panel of experts told advisors during a breakout session at the 6th Annual Inside Alternatives Conference in Denver.

The event, sponsored by Financial Advisor and Private Wealth magazines July 13-14, drew over 600 financial industry professionals.

Risk characteristics, rather than “style box” labels, are a first consideration when evaluating alternative vehicles, said Jeffrey Davis, chief investment officer for Boston-based registered investment advisory firm LMCG Investments. Important risk parameters include correlation to traditional asset classes, how leverage is employed and managed, whether the strategy makes directional bets or tries to time the market, and whether the strategy uses multiple sources of alpha.

“It’s easier to see in liquid alts what the risk nature is because of the transparency that’s required by becoming a mutual fund vs. a hedge fund. It’s much safer for first-time alts investors to be in liquid funds,” Davis said.

But advisors should watch for ephemeral liquidity—another significant risk. “Things that are liquid can suddenly not be liquid. You have to be very careful,” he added.

Davis, who manages the LMCG Global Multi-Cap Fund, said global market-neutral strategies could provide diversification through low to near-zero correlations with other asset classes. They’re also a good way to insure against market declines, he said. “Once you strip out beta, all you have is alpha.”

Because alts often use leverage to amplify portfolio returns, Davis said, advisors need a solid appreciation of fat-tail risk. He recommended the landmark article, “What Happened to the Quants in August 2007?” by Amir Khandani and Andrew Lo, which discusses how several previously profitable quantitative long/short equity hedge funds suffered unprecedented losses.

Davis also suggested avoiding directional bets (such as global macro, managed futures and long-biased long/short strategies), shunning market timing and diversifying sources of alpha across multiple asset classes to create performance consistency. “Alpha diversification tends to smooth out returns,” he said.

Jeffrey Sarti, co-president of Morton Capital, a Calabasas, Calif.-based RIA firm, told the audience that he looks for smaller and niche investment opportunities in real estate to create true diversification and cash flow “in this stupidly low interest rate environment.”

Sarti said he tends to concentrate on funds with $50 million to $150 million in assets. The advantages of this focus are more targeted opportunities and less competition. The disadvantages are increased operational and business risks that are inherent in investing with smaller organizations. “We have to ensure that these smaller funds have appropriate levels of oversight,” he said.

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