Exposure to Alternatives: What’s the Right Allocation?

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Industry studies say 20%. But lack of advisor education is a headwind to adoption.

The liquid-alternatives industry continues to grow dramatically. Net inflows were over $40 billion in 2013 and the growth trend has continued this year. The combination of stretched equity valuations, an uncertain outlook for bonds, and geopolitical turmoil is supporting the case for alternatives.

Investors who understand the purpose and place of alternatives appear to be allocating enough to make a difference. According to MainStay Investments’ recent survey  of more than 800 High Net Worth investors, over 60% are using alternatives, to which they are allocating 22% of their portfolio, on average.  Barron’s most recent annual survey of the top 40 wealth advisory firms reported that these firms also had 20% of clients’ assets allocated to alternatives, on average.

The MainStay survey also reported that over 75% of investors who are having a positive experience with alternatives would recommend them to others.

And yet, advisors’ adoption of alternatives remains limited.

According to the 2013 Morningstar and Barron’s Alternative Investment Survey of institutions and advisors, only 15% of advisors anticipated allocating more than 20% of portfolios to alternative investments over the next five years. (In contrast, 42% of institutions said they will exceed a 20% allocation to alternatives over the period.)

The MainStay study also emphasized that nearly 60% of high-net-worth investors indicate that their financial advisor influences their perception about alternative investments. So what’s holding financial advisors back from recommending alternatives as a meaningful piece of a diversified portfolio?

Helping advisors do their jobs – easier and faster

Advisors tell us it is very time-consuming to research and evaluate alternatives, because no universally accepted benchmarks exist and some products lack transparency – i.e., can’t easily be categorized or evaluated.

To some advisors, the analysis seems to require an excessive commitment of work and time, relative to the portfolio allocations they feel comfortable recommending.  The perplexity is magnified by the huge influx of new products, of many different types. Also, there is no universally accepted definition of alternative strategies.

To confidently recommend alternatives to clients, advisors must first fully understand what they are, how they operate, and how they can be expected to perform in different market environments.

The good news is that once advisors gain conviction, they will recommend alternatives to clients in allocations large enough to make a difference. Advisors also will educate clients on how they work. As clients’ confidence grows, they will recommend alternatives to others.

So, what do advisors need to evaluate alternatives in a way that feels time-efficient? Advisors and gatekeepers tell us they need straightforward answers from product sponsors and fund managers:

• Do you have a hedge fund track record? Is it transparent and GIPS (or equivalent)?
• Can you explain and demonstrate your ability to short?
• Do you invest in your own fund?
• If you are in a Series Trust, is the board adequate and invested?
• What are the capacity constraints of the strategy?
• Is your process transparent and repeatable?
• Is the risk management process demonstrable and repeatable?
• Do you include statistics such as upside/downside capture, correlation, alpha, beta and drawdown?
• Do you compare your performance consistently to the most relevant benchmarks?
• Do you include data on net exposure and portfolio turnover?
• Are your all-in costs comparable to other funds in your category?

In summary, once investors understand the purpose and place of alternatives, they use them effectively.  Advisors play a key role in the adoption of alternatives, but will only recommend strategies in which they have conviction.  Our industry can empower advisors by educating them so that they can confidently present liquid alternatives to their clients.


—April 2014