Alternative shouldn’t be a dirty word

Is there a more loaded term in investing than “alternatives?” As soon as you mention the word to advisors, they often worry about compliance headaches and trying to explain complex investment structures to clients.

Still, investors may need portfolio exposure to alternative assets to protect themselves from downside risk during a rapidly rising stock market. But just like some of the high-profile hedge fund failures, it’s the cost of getting alternative exposure that’s really given the space a black eye.

Read:

• TSX run isn’t done, say experts
• More investors partnering with hedge fund managers

Reducing fees on alternative investments can make them more attractive for risk protection, and also improves the risk-adjusted returns of a portfolio.

Managed futures, for example, remain one of the few sources of non-correlated returns left to investors. Their potential is illustrated by looking at the returns they generated during the financial crisis. The Barclay CTA Index, an index of licensed commodity trading advisor and managed futures strategies, delivered a nearly 100% return between March 6, 2009 and May 1, 2011, when the S&P 500 only returned 6.74%.

Non-correlation is a key determinant of risk protection in a portfolio. But the average Canadian investor’s portfolio is most likely comprised of different types of exposure to stocks and bonds. Stocks and bonds are typically inversely correlated, so when stocks are up, bonds tend to be down, and vice versa. The net return for the investor may be negligible overall, unless they’re overweight in one of the two asset classes.

Allocating between 5% and 20% to an alternative investment such as managed futures, or alternative strategy indices, could bring additional diversification benefits. During bull markets, alternative investments tend to lag the returns of traditional asset classes. For example, the Barclay CTA Index cited earlier is down about 2.40% this year, while the S&P 500 is up more than 25%. This is often when you get investor complaints about the fees they are paying on alternative mandates.

Read: Mortgage investing offers opportunities

A portfolio that holds a combination of stocks and managed futures is currently underperforming, although the portfolio would still be generating healthy returns. Investors shouldn’t look at alternative strategies in isolation. Rather, they should consider the risk protection benefits they offer a total portfolio.

A football analogy

Alternative ETFs can be the blindside tackles of a portfolio.

These players protect the quarterback from being hit from behind (the blindside). It’s a specialized and expensive role to fill, but crucial to the success of the team. But no one should build an entire football team of blindside tackles. Alternatives are the same.

Institutional investors know this. Some have large allocations to alternative asset classes. If you peruse the most recent annual reports of large pension and endowment funds, you’ll find the following allocations:

• Yale Endowment Fund: 58% (includes resources, absolute return strategies and private equity)
• OMERS: 47% (private equity, private market and real assets)
• Harvard Endowment Fund: approximately 40% (includes resources, absolute return strategies, real assets and private equity)
• Ontario Teachers Pension Plan: 37% (includes commodities, absolute return strategies and real assets)
• CalPERS: 15% (includes resources, absolute return strategies and private equity)

These funds generally have longer time horizons compared to individual investments, and therefore their allocations to alternatives can be larger. But they appear to understand that holding a binary portfolio of stocks and bonds exposes them to too much risk.

Read: Alternatives a solution to high correlations

ETFs can now help close the gap between well-constructed institutional and individual investor portfolios. Some of the biggest barriers to alternative investing have been expensive management fees, which in some cases still exceed 4% annually, as well as strict investor qualifications, such as a prohibitive minimum investment size.

Innovations in indexation—most of which can be replicated by ETFs—have allowed alternative strategies, like managed futures and hedge funds, to be indexed. This reduces costs, often by more than half, and increases transparency without eroding the performance and risk benefits of having an allocation to these alternatives.

Read: Benchmarks are outdated

How alternatives boost portfolios

Retirees and institutional investors share the same priorities.

Both aim to reduce portfolio volatility and maintain steady streams of funds, says Faizan Dhanani, an executive vice president at Horizons ETFs. To achieve this, many institutional investors are shifting away from conventional 60/40 portfolios, he adds. The move is crucial since the correlation between traditional asset classes—such as equities, bonds, fixed income and gold—is rising.

Along with bond yields dropping from between 6% and 8% to between 1% and 3%, Faizan has found commodities and many large-cap, small-cap and fixed-income securities are performing more like equities.

As such, most major institutional funds have turned to alternatives such as real estate and private equity, to beef up their yields. The Yale Endowment Fund has allocated more than half (58%) of its portfolio to alternatives, says Faizan, and in Canada, OMERS has allocated 47% and the Ontario Teacher’s Pension Plan has invested 37% in alternatives.

Since those asset classes are hard to break into for average retail clients, he suggested you help them look for funds that offer exposure. People should also consider investing in ETFs tied to hedge funds, managed futures and corporate bonds to help diversify their holdings, Faizan adds.

–Katie Keir, assistant editor of Advisor Group

Source: Blooomberg, as at August 31, 2013

Howard Atkinson is president of Horizons ETFs and the Canadian ETF Association.