Alternative investments take the sting out of the market

Retirees need some equities exposure, but they also must hedge their bets

Retirees without alternative investments in their portfolios are at the mercy of the general direction of the markets, according to Gabriel Burstein, global head of investment research at Lipper Inc.

“More than 90% of all retirement accounts are invested in long-only investments that only go up when the market goes up,” he said. “Unless advisers want their clients to be prisoners and hostages of the market’s direction, this has got to change.”

Such a change already is well under way on the product end, where money managers are ramping up and rolling out a wide range of registered alternative strategies in the form of mutual funds and exchange-traded products.

According to Cerulli Associates Inc., the asset management industry launched 65 alternative-strategy mutual funds last year, compared with 45 the year before.

Asset flows into alternative mutual fund strategies were up 60% from 2009, compared with a 16% increase for all other long-term mutual funds, according to Cerulli.

While such data might suggest a new awakening to the benefits of alternatives among investors and financial advisers, there remain lingering questions with regard to exactly how and why investors are turning to alternatives.

That uncertainty is seen as part of what is preventing more advisers from using alternatives in retirement accounts, where, it could be argued, they are needed the most.

“Retirees are going to eventually be faced with rising interest rates, and unless they plan on holding individual bonds to maturity, they’re looking for some fixed-income substitutes,” said Tom Florence, chief executive of 361º Capital LLC, which builds fund-of-hedge-fund portfolios.

Along those lines, the 361 Absolute Alpha Fund (AAFAX), launched in December, is a registered market-neutral mutual fund that targets a total return of between 6 and 10 percentage points above that of short-term Treasuries.

The fund reduces market volatility by shorting the broad equity market indexes, while letting underlying subadvisers take long positions in select equities.

“With about a third of the market’s risk, this is the kind of fund that can be a fixed-income alternative without investing in fixed income,” Mr. Florence said.

An InvestmentNews survey of financial advisers found that when using alternatives in their clients’ retirement portfolios, 76% are using real estate investment trusts.

The next-most-popular alternative is commodities at 59%, followed by absolute-return funds at 40% and precious metals at 34%.

The top allocations correspond well to performance, according to an analysis by Arrow Investment Advisors LLC. Between January 2000 and March 2011, REITs produced an average annualized return of near 13%, it found.

Managed futures came in at 12%, commodities were just below 14% and gold was at more than 15%.

Equities, meanwhile, produced a return of less than 1%, while bonds returned just over 6%.

The point, according to Arrow chief executive Joe Barrato, is that a portfolio comprising merely stocks and bonds can get crushed for long periods of time, which is a reality for which most people in retirement are not prepared.

SHORT HORIZON

“Markets typically move in investment cycles, and over the long term, that works, but most investors don’t have a 60- or 80-year time horizon,” he said.

Tom Orecchio, principal at Modera Wealth Management LLC, is among those financial advisers well versed in the use of alternatives, but he also recognizes some of the challenges facing advisers who might be new to that market.

Mr. Orecchio, whose firm has $450 million under advisement, prefers his alternatives to be far from the mainstream, meaning most registered products, such as mutual funds and exchange-traded funds, will be avoided.

“To the extent I can do it, I like to treat alternatives like alternatives, which means I try to buy it in the original format, and not in something that is traded on the equity markets,” he said.

To some advisers, and much of the retail-asset-management industry, such advice might seem jarring, since easy-to-use alternatives are what the financial services industry is increasingly trying to peddle.

Mr. Orecchio acknowledges that a mutual fund employing an alternative strategy such as long-short equity is better than no alternative exposure at all, but he also believes that the more mainstream a product becomes, the less alternative it becomes.

“With ETFs, for example, you can pretty much get any alternative exposure you want,” he said. “But they trade like equities because it’s in a liquid format and people will trade it.”

A classic example, he added, is the difference between a long-term, less liquid real estate investment and a listed real estate investment trust, which can be bought and sold every day.

However, because many of the purest alternatives come with higher minimums, higher fees, less liquidity and less transparency, the packaged route via mutual funds and ETFs is often the only option for some investors.

E-mail Jeff Benjamin at [email protected].