“Alternatives are not an asset class. They are going to perform very differently from each other,” Wyatt said. “A lot of people get into trouble defining alternatives as an asset class.”
You need to measure against the appropriate asset, like equities, commodities or debt, she said. If an alternative strategy is designed to be a hedge, be sure it is acting inversely to the hedged asset.
Carter likes to understand how alternative managers handle their mistakes, and how they recover from their biggest ones.
Advisors need to be careful, Wyatt warned. “You don’t have the luxury of making a mistake” because most alternatives are long-term investments and may be hard to get out of. “They require a high level of due diligence,” she said.
Investors should also be aware that the alpha being delivered by alternative managers “has gone down to its lowest level historically,” Wyatt said. “There are a lot of managers chasing a lot of strategies, and adding fees.”
Lower levels of leverage can explain some of the lower returns. “The early [hedge fund] managers had 10 or 20 times leverage [but] access to leverage has basically deflated” after the financial crisis and passage of the Dodd-Frank Act, Wyatt said.
Wyatt and Carter said investors should avoid funds of funds, which have layers of fees, too many managers who dilute performance, and difficulty following a large group of managers.
Clients need to be educated, Carter added, and prepared for periods of underperformance, while advisors should be sure to explain what hedge funds are before recommending them. Clients hear the phrase “hedge fund” and immediately think of risk and shady Wall Street operators, he said.
Carter and Wyatt are both opportunistic in using alternatives.
Wyatt, for example, is adding gold to client portfolios, as she did in 2007, and is also looking for opportunities to invest in infrastructure.