Investors enjoying recent fat stock returns and using conventional diversification strategies could be sorry in the next crash.
That is the implicit message of those who argue for an emerging investing style, liquid alternatives. It’s a broad asset class that became popular in the wake of the 2008 financial crisis, shunning long-only investing while promising downside protection. But how can an advisor know this kind of defensive investing will perform like its supporters claim it will?

One problem is that alternative funds, often sold as insurance against bad markets, have short track records. Most are less than 10 years old, so they’ve experienced a period of mainly good markets. Indeed, of the 20 largest of these funds, only three go back beyond 2008 (See chart).

A leading fund industry observer says alternatives are theoretically a good idea, but possess their share of problems. Yet John Rekenthaler, Morningstar’s vice president of research and a fund analyst, maintains that alternatives can still be an effective part of a portfolio. “The idea of having lower-volatility assets that are only loosely correlated with stocks (if they are correlated at all) makes sense. You can’t argue with the math,” he says.

Liquid alternative fund supporters, who note that the style has only become widely available to retail investors since the crash, think people who shun these funds sometimes misunderstand them, and that advisors without them aren’t effectively diversified. It’s not enough for investors to just have bonds and stocks or real estate or foreign stocks and believe a black swan crisis won’t inflict serious damage on them. In the last crash, both bonds and stocks had problems simultaneously.

Some advisors who have used alternatives extensively believe many of their colleagues misunderstand these vehicles. Bill Carter of Carter Financial Management in Dallas discovered them by serving on the investment committees of non-profits and endowments for several decades. “The reason an advisor buys alternatives for clients is not to increase returns: It is to reduce risk and volatility,” he maintains.

Indeed, in a period of uncertainty, “it will become even more important to find investments and strategies that are not sensitive to the performance of stocks and bonds, and will not be so strongly impacted by central bank actions and changes of directions,” writes Michelle Borré, a portfolio manager of Oppenheimer Fundamental Alternatives Fund and lead portfolio manager of Oppenheimer Capital Income Fund.

Like Rekenthaler, Borré’s primary argument for alternatives is their record in difficult markets. She cites three bust/bad periods when alternatives—then only available to well-heeled investors—performed better than conventional long-only funds. The latter, Borré argues, tanked because they were more correlated than diversified.

“During the financial crisis [of 2008], the correlations spiked across the board and for some asset classes—like real estate and international equities—correlations went to 1,” Borré writes in her recent paper for Oppenheimer Funds, “Alternative Strategies Now and Going Forward.” “That created a lot of problems during the crisis for those who relied on these traditional asset classes for diversification.”

The logic for owning alternatives extends beyond the need for downside protection during periods of financial stress. Many strategies are designed to churn out pedestrian but consistent returns of between 5% and 10%, which looks good compared with most bond funds. Long-only equities, in contrast, historically could generate double-digit returns for a decade or more, only to tread water for the next decade. Sometimes, these so-called lost decades occur after equities reach some milestone, like Dow 1,000 or Dow 10,000. (Dare anyone say Dow 20,000?)

However, some who bought into the diversification argument after 2008 are unsatisfied. They see alternatives as a category that has been outpaced over the last eight years as interest rates stayed low and equity performance shined. “Most funds have relatively short track records while performance of longer-tenured funds has been disappointing,” said a recent Morningstar Landscape report.

Still, some fund families have introduced liquid products that performed acceptably. AQR has led the pack, but John Hancock Funds, Oppenheimer Funds, Principal and smaller shops like Litman Gregory and Lake Partners have attracted a following.

Part of the dilemma surrounding liquid alternatives is deciding what role they play in a portfolio. If advisors substitute them for bonds, single-digit returns look satisfactory. However, many funds emerged from the illiquid hedge fund world a decade ago when these vehicles were producing disparate, but sometimes spectacular, returns.

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