When alternative becomes mainstream, is it really alternative anymore?

A growing number of financial advisors and their clients are clamoring for alternative investments in the wake of the massive market maelstrom of '08-'09, when most traditional asset classes went down the toilet together. As a result, investors increasingly are looking for ways to diversify their portfolios with non-correlating assets that will do the proverbial zig when stocks and bonds zag.

A survey by Rydex/SGI found that 81% of registered investment advisors and 79% of broker-dealers believe that traditional asset allocations of stocks, bonds and cash don't offer enough portfolio diversification.

According to Cerulli Associates, 76% of asset managers believe the downturn helped the case for alternative investments, and that 40% of financial advisors plan to boost the amount of alternatives in client portfolios.

But as more people jump on the alternative investments bandwagon, will that lessen the opportunity to exploit the inefficiencies that potentially make these strategies an effective counterbalance to the traditional investment landscape?

Before they ask this question, though, investors first need to determine what the heck alternative investments are. There isn't a consistent definition for this space, which can pose problems for advisors who want to allocate these investments in client portfolios.

"In my opinion, I don't believe there's a clear concept of what alternative investments are," says Ted Gregory, a financial planner in Huntington Beach, Calif. "There needs to be a continuum on which most advisors could agree. Maybe there is, but I'm not aware of it."

It's a concern shared by others. "I recently spoke with a key account manager [from an asset management company] who deals with the big wirehouses, and he says that one of the big challenges when speaking with these firms and their employees is making sure people are talking about the same thing because everyone describes alternatives differently," says Pamela DeBolt, a Cerulli analyst.

In the simplest terms, the consensus holds that alternative investment vehicles should have a low correlation to equity and fixed income. In addition, they should generally employ both long and short strategies.

From there, things get a little sticky. Real estate (or at least publicly traded real estate investment trusts) and commodities (at least on the long-only side) were once thought to have low correlations to stocks and bonds, too, but some folks have booted these securities from the alternatives club after they nose-dived during the downturn and failed to demonstrate the anticipated diversification. And there's some debate about whether even gold is truly an alternative asset anymore.

Generally accepted in the category are hedge funds or hedge-style alternative strategies that include long-short, event driven, market-neutral, global macro, merger and convertible arbitrage, relative value, directional/tactical, managed futures, short bias and options strategies. And you might add distressed debt and forward contracts to the mix, although Cerulli found that asset managers haven't agreed on whether they are alternative.

The cost of entry to alternative strategies (read: private hedge funds and funds of hedge funds) can be prohibitive with their high investment minimums and fees. And the risks-such as short selling, derivatives, leverage and illiquidity risks-can be substantial.

At the same time, the growing number of alternative-oriented mutual funds and exchange-traded funds governed by the Investment Company Act of 1940 have brought some of these alternative strategies to the masses at a fraction of the cost and with less leverage and liquidity risks. Players in this space include AQR, Rydex / SGI and Eaton Vance.

Proponents of alternative investments believe they serve a very useful role in portfolio diversification by reducing risk. In other words, the objective with alternatives isn't hitting the cover off the ball as much as it is making sure the cover doesn't completely unravel.

"To us, it's about looking at the Sharpe ratio and risk-adjusted returns," says Ira Rapaport, CEO of New England Private Wealth Advisors LLC in Wellesley, Mass. "It's not about the highest returns."

Hedging Your Bet
To some people, there's no doubt the road of less correlation to stocks and bonds goes through alternative investments.

"There's no way you can have an efficient portfolio without having investments with different risks," says Ed Butowsky, managing partner of Chapwood CustomHedge Portfolio Advisory Services in Dallas. "And alternative investments are one of the easiest ways to get that low correlation because you can't get it in the long-only world anymore."

Butowsky says the typical asset allocation among advisors, at least those whom he works with, comprises roughly 70% equities (the vast majority being U.S. equities) and 30% fixed income and cash. During the 11-year period through December 2009, he found that this type of portfolio had an average annual rate of return of 4%, a standard deviation of 14 and a 37% chance of a loss in any given year.

Butowsky says replacing 25% of that so-called typical portfolio with alternative investments-comprising distressed securities and event-driven fund managers, along with managed futures-led to an average rate of return of 10%, a standard deviation of seven (lower is better) and a 7% chance of losing money in any given year.

Butowsky's firm helps advisors put alternatives into client portfolios by tapping into a network of roughly 60 hedge fund managers. "We complement existing portfolios by analyzing them to see what their Sharpe ratio is, how much risk they have and what their historical returns are," he says. "Then we look at our list of candidate managers and blend together portfolio managers to potentially make the portfolio more efficient."

Still, despite a changed regulatory environment, the hedge fund industry remains a shadowy, unregulated world that requires significant due diligence. "When people look at alternatives they need to look for managers with at least a ten-year audited track record and have an identifiable process in place," Butowsky says. "You should know who their administrator is and who's doing the prime brokerage for the hedge fund. And you want to make sure the numbers come from a credible third-party administrator, and not from the manager."

No Panacea
Alternative investments aren't a blanket cure for market volatility. For sure, certain investment goals require specific strategies.

"If you want true diversification, then maybe you want managed futures with low historical correlation," says Jon Sundt, the president and CEO of Altegris Investments in La Jolla, Calif. "If you want absolute return to make money in any investment cycle, you're looking at arbitraged strategies and M&A, global macro or managed futures. Or if you want exposure to the general market but don't want exposure to the downside, there's hedged equity strategies such as long-biased and long-short funds-both domestic and emerging markets."

Altegris provides alternative investment platforms for advisors that access top hedge fund managers, managed future funds and other alternative investments. "The hard part for advisors isn't the fees associated with hedge fund managers, it's getting access to them," Sundt says. "There are 6,000 to 7,000 hedge funds, and it's hard to establish relationships with the best ones."

But performance can vary, as it does with any asset manager or asset class. Sundt says the best assets in 2008 were with managers who shorted credit and those long-short managers who were truly market neutral. "We had some managers who were down 6% to 7% in 2008 who had equity exposure but were truly hedged," he says. "Managed futures were up 15%. Some global macro managers, as well as managers trading sovereign debt and currencies, did well."

Last year was a different matter, particularly with managed futures, which as an asset class lost 8%. "I think one of the things that challenges advisors is that these alternative strategies go through cycles that are usually very different than traditional asset classes," says Rick Lake, co-chairman of Lake Partners, a Greenwich, Conn.-based RIA specializing in hedge fund and alternative strategies.

Asset managers are rolling out increasing numbers of '40 Act mutual funds and ETFs with an alternative bent aimed at Main Street investors, and this is helping to fuel demand.

"It gives financial advisors more flexibility to invest in more asset groups," says Andrew Rogers, president of Gemini Fund Services LLC in Hauppauge, N.Y. "It's another tool in the RIA toolbox to boost diversification."

Gemini is a back-office administrator that provides marketing, registration and other services to help mutual funds and hedge funds bring new products to market. Rogers says business is booming in the alternatives space, but acknowledges that many of these funds have slim track records of three years or less.

"I think that's a legitimate concern," Rogers says.

According to Morningstar, funds employing alternative strategies flooded the market in the last decade, most of it coming since 2006. As of February 11, Morningstar counted 378 alternative-style funds-150 mutual funds and 228 ETFs.

Morningstar's alternative mutual funds categories comprise long-short (which uses shorting but remains net-long or neutral); bear market (which have a net-short equity exposure); and currency plays (which include spot currency and forward or future contracts). By far, the long-short category is the biggest.

But Morningstar says the average long-short mutual fund is highly correlated to stocks, and that bear market funds have poor average risk-adjusted returns. From October 2003 through December 2009, the benchmark 60-40 portfolio's annualized return was 4.49%. Meanwhile, the Morningstar currency category's annualized return was 3.3%, the long-short category gained 2.21% and the bear market category lost 11.12%.

During that period, the maximum drawdown (the peak-to-trough decline) on the 60-40 bogey was minus 31.86%. The maximum drawdown for the currency category was minus 3.73%, followed by the long-short (minus 22.94%) and bear market (minus 52.14%) categories.

More asset managers want a piece of the action even if they don't belong. Morningstar alternative investments strategist Nadia Papagiannis says one fund with 80% of its assets in long-only investments wants to be put into the long-short category because its managers believe the fund's REIT, currencies and natural resource assets qualify it as being alternative.

"Another thing I'm seeing is that some global tactical allocation funds are trying to hop on the alternative bandwagon when they're really just tactically allocating long-only, highly correlated assets," she says.

Indeed, alternative investments have become the new "it" girl. "When something is hot, it's a cause to pause and ask whether it means there's a bubble," says David Kabiller, founding principal at AQR Capital Management. "That said, individual investors have plenty of stock and bond choices, but they are missing a tool because they don't have many alternative choices. The world doesn't need another large-cap value manager."

Based in Greenwich, Conn., AQR is part of a small but growing number of asset management companies specializing in hedge fund strategies that are bringing alternative strategy-based funds to the '40 Act world.

In AQR's case, it oversees the Managed Futures Strategy and Diversified Arbitrage funds. The latter fund takes a multi-pronged approach employing merger arbitrage, convertible arbitrage and other arbitrage strategies.

"There's a convergence between alternative investment vehicles and the managers offering them," Papagiannis says. "Hedge fund managers are starting to offer mutual funds and traditional managers are starting to offer long-short strategies. Basically, alternatives will become vehicle-agnostic at a certain point and will be accessible in different ways."

Sounds very democratic, but these funds aren't full-throttle alternative investments. "You get a kinder, gentler middle ground," says Rick Lake. "The difference is you can either buy liquid alternatives in a low-cost structure, or you can buy more aggressive niche alternatives that require a private structure."

Some people consider these '40 Act funds to be alternative investments "lite."

"The biggest issue is a '40 Act fund can't charge an incentive fee, which limits the universe of available managers in the traditional hedge fund world," says Sundt from Altegris. "There are other issues like restrictions on leverage, illiquid securities, derivatives limits, etc. But the main issue is the inability to charge an incentive. If you are a very talented hedge fund [manager] with $15 billion of capacity and you have no problem filling it with paying customers, you aren't going to offer your services to the masses for less. That does not mean that there aren't good choices in '40 Act funds. They just aren't 'the goods' yet."

Kabiller acknowledges the legal constraints on '40 Act funds. "The rules of '40 Act funds may make some of these strategies lighter in that they can use only so much leverage and illiquidity," Kabiller says. "Some of the biggest returns are generated by leverage and illiquid risks, so some of the legal constraints mean returns won't have as high an octane."

For some people, that's a good thing. "Limitations can be a positive because so many hedge fund managers failed in 2008 because they took too much leverage and illiquidity risks," says Rapaport, the Massachusetts financial planner. "The negatives here can be viewed as a positive."

Another Alternative
Larry Swedroe, principal and research director for the Buckingham Family of Financial Services, posits that the only alternatives investors need are real estate, U.S. Treasury vehicles, commodities, international equities, fixed annuities and stable-value funds.

Swedroe says he sees hundreds of portfolios a year, and most are heavily tilted toward U.S. large-cap stocks on the equity side. And on the fixed-income side, he's found people using lots of convertible, emerging market and junk bonds. "These are the wrong kinds of diversifiers," he says.

Given the composition of portfolios he sees, Swedroe says real estate, commodities and U.S Treasurys and Treasury Inflation-Protected Securities (TIPS) provide adequate diversification over time. But he bristles when he hears people say that the real estate and commodity sectors' poor performances during the '08-'09 downturn means these sectors aren't proper diversification vehicles.

"The issue is there are some risks that affect all risky assets the same way," Swedroe says. "So when systemic risk shows up, such as a global financial crisis, the correlation of all risky assets tends to go to one. The benefits of diversification aren't perfect and don't always work in the short term. But it means you need the right kind of diversification. U.S. Treasurys will do that when risky assets get hit. You need discipline to stay the course and rebalance during those periods."

Swedroe says the S&P 500 suffered a 9% cumulative loss in the last decade, while emerging market value stocks enjoyed a 225% gain, small-cap international value stocks leaped 199% and real estate increased 176%. "To say that type of diversification doesn't work is total crap," he says.

Another point to consider with alternative investments: Errors and omission insurance policies don't always cover them. The big problem is that the alternative investment space is so broad and ill-defined that insurance brokers are very careful about assigning coverage. "There's no policy that's the same," says Rob Erzen, area vice president at Arthur J. Gallagher & Co., an insurance broker in Aliso Viejo, Calif., that writes policies for the financial advisory industry.

Erzen says it's generally harder for broker-dealers-particularly smaller ones-to get E&O coverage for alternative investments because the broker-dealer space has historically had bigger losses than the RIA space, which makes insurance brokers less willing to write policies for something like alternatives.

"The policy grants are generally easier for RIAs," Erzen says.

Too Much Love?
Naturally, there's a disagreement about whether too much money chasing alternatives makes it harder for some of these strategies to do what they're supposed to do. For example, too much capital flowing into arbitrage situations can depress the spreads in the price differential caused by market inefficiencies, making it harder to exploit them.

"Some of these strategies take more skill in terms of engineering and infrastructure," says AQR Capital's Kabiller. "These are unique strategies that can't be scaled. I think the hedge fund industry sowed the seeds of its own difficulties by getting too big for itself. But it inevitably gets smaller as people pull money from it."

Sundt disagrees to an extent. "The entire hedge fund universe is about $1.4 trillion," he says. "That pales next to the $30 trillion for traditional assets. Even the biggest hedge funds-which are about $25 billion to $30 billion-would be small funds for a lot of fund families. It depends on what they trade and what are the strategies they use."

Meanwhile, investors are piling into alternatives. Lake says he's seen some classic 60-40 balanced portfolios allocate 20% to 25% to alternative investments, and that some family offices have used more than 40%. "Family offices might have a lot of cash and bonds to handle income requirements," he says. "Advisors who are introducing alternatives into their portfolios might use 5% to 10%."

Rapaport typically suggests allocating 3% to 15% of his clients' portfolios to alternative investments. This includes funds of hedge funds for his ultra-high-net-worth clients. For nonqualified clients, he'll recommend utilizing '40 Act mutual funds that employ investment managers that replicate hedge fund strategies for retail investors by using various liquid and transparent investments.

"I think there's a misconception where people think of hedge funds as high risk," Rapaport says. "Clearly, some of these strategies didn't work. You have to be selective and understand how it fits into a portfolio."