Alternative strategies fight index investors while longing for a ‘black swan’ event

Ever since the 2008 financial crisis, when virtually every asset class morphed toward a suddenly singular correlation of declines, the case for diversifying into alternative investments has sounded logical.
But, also ever since the financial crisis, the stock market has been riding the various fiscal and monetary policies that have fueled a strong case for just camping out in a simple equity index fund.
Why diversify when the S&P 500 Index just keeps climbing higher?

That reality was on full display earlier this week at the InvestmentNews Alternative Investments conference in Miami, where a mix of presenters and financial advisers wrestled with how, when and why to diversify into alternatives.

Even the widely unexpected outcome from the presidential election didn’t prove to be enough of a problem to justify a little diversification away from what is essentially your father’s portfolio of 60% stocks and 40% bonds.

The stock market swung wildly when it became obvious Donald Trump was going to beat Hillary Clinton to become the next president. But the recovery was so swift and so similar to last summer’s market reaction to the Brexit vote that nobody even had time to look up from their index funds.

During the conference’s opening keynote session, Tangent Capital chief investment strategist Bob Rice said the election of Mr. Trump was not a black swan event, but an “orange swan” event.

Mr. Rice, who was charged with setting the stage for the case for diversification into alternatives, was presumably making the point that the election was not enough to completely derail the markets while simultaneously chiding the next president on his fruitful skin tone.

Bob Doll, chief equity strategist at Nuveen Investments, who was surveying the post-election landscape, admitted to being caught flat-footed — like a lot of people — by the outcome.

But even as he recognized the mysterious global bond market selloff and the likelihood of higher inflation under a Trump administration, Mr. Doll largely stressed a long-only approach.

The point, echoed throughout the conference, is that if you believe stocks can continue to climb at the pace they’ve been climbing for the past eight years, and if you think bond yields are heading lower, then there’s no need for what could be described as insurance or hedging in the form of alternative strategies.

Also, as Mr. Rice noted, even if you don’t see trouble ahead, the projected annual return for a 60-40 portfolio is a humbling 2.2%, which might be a tough sell for all those advisers pitching advice for nearly half of that return.

The challenges to the status quo of asset allocation resonated with Tish Gray, wealth planning adviser at Sagemark Consulting, who recognizes the evolution of financial products and services.

“Modern Portfolio Theory is good, but we need to be more three dimensional,” she said.
While the alternative investments space has been largely overshadowed by one of the most resilient equity markets in history, it has expanded and deepened its own footprint.

Morningstar counts more than 485 alternative strategy mutual funds, which represents a 185% increase over the 170 funds at the end of 2008.

Assets in those alternative-strategy funds have grown to more than $170 billion, up 400% from less than $36 billion in 2008.

Whether fueled by fear or greed, the alternatives market is gaining ground and simultaneously evolving.

The critics will still have an argument to make about the higher fees, which are slowly being compressed along with the rest of the asset management industry, but they will probably always be higher than your simple index funds.

As Wilshire Funds Management president Jason Schwarz reminded advisers, do not expect long track records when it comes to alternative strategy mutual funds.

“We know that 44% of liquid alt funds don’t have three-year track records,” he said. “And 57% don’t even have $100 million in assets under management.”

There’s reason to believe the assets-under-management data point will start to grow as more institutional investors shift away from more expensive private partnership structures toward mutual funds that are capable of doing essentially the same thing for much lower fees.

The other factors that will boost liquid alt fund assets include a real and sustained market downturn, and a commitment by advisers to allocate more than just a few percentage points of a portfolio to alternatives.

Allocating 5% to alternatives might seem like a prudent diversification move, but until you get to around 15% or more, you’re really just running a more expensive version of the traditional 60-40 portfolio.