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."

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