In the summer of 1982, Duran Duran was atop the music charts, Leonid Brezhnev was still calling the shots in the Soviet Union, and the United States was just coming out of a decade-long economic slump. Back then, the S&P 500 stood at 105.

Fast forward to 2015, and that market index has surged nearly 2,000%. A multi-decade plunge in interest rates has led to stellar returns for bond investors as well. Despite some notable bumps in the road in 2000 and 2008, the bond and stock markets have delivered remarkable long-term returns, enabling many baby boomers to build powerful retirement nest eggs.

Yet few expect the stock and bond markets to deliver such robust returns in the years ahead, and for many the question is whether the remarkably long bull market in stocks and bonds will end with a whimper or a bang.

Pete Wiley, a senior portfolio manager at Whitebox Advisors and Whitebox Mutual Funds, isn’t sure if the market action will be orderly or chaotic. “There are so many conflicting economic signals right now,” he says, adding that steady economic growth would still be necessary to help markets stay on an even keel. “But if economic problems build, we’ll see an abrupt transition in market sentiment.”

At this point, a quick history lesson about stocks and bonds is helpful. From the 1960s through the end of the 1970s, “stocks and bonds were negatively correlated,” notes Jeff Sarti, co-president of Morton Capital Management. Since the early 1980s, however, these two asset classes have often moved in lockstep. They have both benefited from falling inflation, rising corporate productivity and, more recently, a fire hose of liquidity from the Federal Reserve.
A changing Fed stance regarding liquidity may have an equally deleterious effect on both asset classes. “We’re very concerned about central bank policy. … We’ve had a free lunch thus far,” says Sarti, adding that if stocks lose ground, “bonds are unlikely to be the diversifier they once were.”

Still, a fixation on interest rates has been a losing game. “Chief investment officers have spent too much time anticipating rate moves and have lost a lot of money in terms of opportunity cost,” says Jeff Davis, chief investment officer of LMCG Investments.

As far as Davis is concerned, near-term interest rate increases aren’t the challenge. “It’s the market’s reaction to the events that we’re more concerned with.” That’s a view shared by Ben Hunt, chief risk officer with Salient Partners. “The key question to ask will be, ‘Why are rates rising?’” says Hunt.

Hunt has noted a widening spread between high-yield bonds (typically “BBB”-rated) and 10-year Treasurys. A further expansion in the interest rate spread may signal rising balance sheet risk and pressure on corporate profits.

Hunt adds that he’s keeping close tabs on Europe, not to watch the impact of a Greek exit from the euro, but to watch what larger countries such as Italy might do about their own economic strains. An Italian (or Spanish or French) exit from the euro could broadly destabilize global markets.

Concerns about central bank policy in the United States, Europe and Japan are being expressed by a range of asset managers and financial advisors. “There are some unintended consequences of the quantitative easing that the Fed, for example, wants to avoid,” says Ben Warwick, the CIO at Quantitative Equity Strategies and a member of the team that manages the Aspen Managed Futures Strategy Fund (MFBTX). “The Fed has changed the whole dynamic of risk-taking, which has greatly aided ‘risk-on’ assets in recent years.”

Well before the Fed began priming the liquidity pump in 2008, bonds had already been enjoying a remarkable bull run. So it’s hard to predict how interest rates and bond prices will respond to the changing economic environment. “We’ve been in a bond bull market for so long that we have little recent history to go on,” says Whitebox Advisors’ Wiley.

Frankly, it’s unclear how such factors will play out. But there is a growing consensus that investors need to broaden their exposure to assets outside of the traditional bond/stock axis and toward what’s known as alternative investments.

Few are calling for a complete withdrawal from stocks and bonds, but Michael Underhill, co-founder of Capital Innovations, notes that major investment offices at Harvard, Yale and elsewhere now hold 20% to 25% of their portfolios in alternative investments.

Underhill wrote The Handbook of Infrastructure Investing in 2010, and today guides a fund run by his firm called the Capital Innovations Global Agri, Timber, Infrastructure Fund (INNAX). He’s a fan of “real assets” and has added niches such as toll road operators to his purview.

In search of other alternative investments? Well, a range of options exist. Many were once only accessible to hedge fund managers with billions in assets under management. But the choices are widening, making them more accessible to financial advisors and retail investors.

Whitebox’s Wiley says his firm tends to seek out investments that will hold up during a rising rate environment. A good chunk of the Whitebox Tactical Advantage Investor fund (WBIVX) is currently focused on the highest-quality end of the high-yield bond market (the “BB’s”) and the fund pairs those holdings with a hedging short position in short-dated U.S. Treasurys. Wiley is also a fan of bank debt. “They are floating-rate by nature, so their coupons will adjust upward if rates rise,” he says.

Morton Capital’s Sarti is gravitating toward less liquid investments these days. “Traditional assets such as bonds are becoming very expensive,” he says. He thinks “investors are paying up for liquidity in part because liquid assets have done extremely well in recent years.” As a result, less liquid assets appear to offer better relative value these days.

One area of focus: private lending. “Banks have retrenched from traditional lending, and a void has been created,” says Sarti. Other illiquid assets his firm currently favors are real estate equity, oil and gas partnerships and health-care royalties.

That last category is the kind of investment that offers long-term returns uncorrelated to public market benchmarks. In a nutshell, investment firms such as Morton Capital, through intermediary funds, provide financing to biotech firms, universities and drug inventors in exchange for a slice of future cash flows once products hit the market. “It’s helpful to biotech firms that still have funding needs, can’t tap bond markets and don’t want to dilute existing shareholders,” says Sarti.

Another asset class with virtually no correlation to stocks and traditional bonds is “catastrophe bonds.” These are issued by reinsurance companies that need to shore up their own capital bases after major insurable events such as hurricanes, earthquakes and other “acts of God.” Because these bonds address different types of events in multiple regions, they tend to make great diversification tools, even within the same asset class.

Of course, the most popular way to gain alternative investment exposure is through liquid alternative investment mutual funds. These follow traditional hedge fund strategies and provide the added benefits of liquidity and transparency while avoiding the deep asset concentration that some hedge fund managers tend to pursue.

Trouble is, it can be hard to know where to start. Morningstar tracks more than 600 liquid alternative funds spread among 15 subcategories. When investors look only at those pursuing hedge fund-style alternative strategies, the field is narrowed to around 325 funds, Goldman Sachs Asset Management has noted.

Leading liquid alternative fund categories include equity long/short strategies, event-driven strategies, relative value strategies, tactical trading/macro strategies and multi-strategy approaches. If interest rates rise, and possibly end the current bull market, many investors would like to know which of these categories are poised to deliver the best risk-adjusted returns in coming quarters.

That’s the wrong way to look at it, according to Larry Restieri, the chief operating officer for Goldman Sachs Asset Management’s third-party distribution business in the U.S. “It’s very hard to predict which subsector will be the top performer in the near term,” he says. Instead, “you need to have a long-term strategic approach with these funds and not just trade them for the next six to 12 months.”

That view is shared by Morningstar’s John Rekenthaler. He looked at the fund flows for various liquid alterative investment categories over the past seven years, and the results “show fund investors chasing the hot investment categories, always arriving after the good news.” Invariably, such bad timing leads to subsequent underperformance, which can sour investors on the virtues of these strategies.

Instead, investors should focus on high-quality funds and accept the fact that, as a portfolio hedge, they play a long-term role, not a short-term one. How to find the best funds? The key to success with liquid alts is to find managers with deep experience in their strategies but who also have experience running a mutual fund, says Nadia Papagiannis, the director of alternative investment strategy for global third-party distribution at Goldman Sachs Asset Management.
She believes that many hedge fund managers aren’t always well-suited to handle the complexities of mutual fund regulations, as spelled out by the Investment Company Act of 1940.

To be sure, it can be very time-consuming to research and identify an ideal manager for each of the liquid alternative subcategories an investor chooses to pursue. That’s why Goldman Sachs’s Restieri and Papagiannis think it’s wiser to consider funds that glean exposure to multiple strategies and the expertise of multiple fund managers.

One key drawback: “Funds that employ multiple managers to run separately managed accounts tend to be the most expensive in the category, with expense ratios well north of 2%,” wrote Morningstar’s Jason Kephart in a note to clients.

That may explain why Morningstar fails to anoint any of these funds with “Gold” or “Silver” medals, although seven of them have garnered “Bronze” stars. Of these funds, the MFS Global Alternative Strategy I Fund (DVRIX) has delivered a category-leading 6.9% annualized return over the past three years (at least among the seven funds that are Morningstar medalists). The fund’s 1.15% expense ratio is among the lowest in the category.

If you look into the crystal ball, you may see a stock market that is still rising in six to nine months. Bonds, for that matter, may also muddle along in a benign fashion. “The path of least resistance is to continue in the same direction,” notes Morton Capital’s Sarti. Yet he and many other market watchers know that troubles lurk beneath the surface.

In effect, market performance has become decoupled from economic performance. As far as Sarti is concerned, “the imbalances will only become more extreme.” That backdrop makes this a good time to boost your exposure to alternative investments. They may not be poised to deliver sharp gains, but they appear to be quite well-suited to the goal of capital preservation.