Alternative strategies prove their worth as stocks turn bearish

As stock market volatility returns in earnest, investors who have waited patiently in alternative investments are starting to reap some of the benefits.

Though liquid alternative mutual fund categories have generally been out of favor against the backdrop of the roaring multiyear bull market for stocks, over the past few months, most categories have stepped up as noncorrelated strategies.

Market-neutral funds, which aim to reduce market beta risk, are down just 26 basis points on average over the past 90 days, according to Morningstar Inc. Over the same period, the S&P 500 Index is down 5.86%.

Category averages can be misleading, which is illustrated by the three-month performance range — from a gain of 6.12% to a decline of 6.44% — for the market-neutral funds in the Morningstar category.

But the category average vastly outpaces the performances of all nine Morningstar equity-fund style box categories over the past three months, which range from a decline of 5.49% for large-cap value funds to a decline of 14.12% for small-cap growth funds.

“For the past few years, as the stock market has been climbing, we’ve been battling with clients to stay in alternatives,” said Dick Pfister, founder and president of AlphaCore Capital, a firm that allocates between 15% and 30% of client portfolios to alternative strategies.

This year through September, a globally diversified portfolio of 60% stocks and 40% bonds outperformed a portfolio of stocks, bonds, and alternatives by 4.5%.

But since Oct. 1, that performance gap has closed, and Mr. Pfister expects portfolios that include alternatives to start outperforming long-only stock and bond portfolios as the volatility continues.

“Some people will still say it will take more equity sell-off for them to be convinced, and riding the highs and lows of the equity markets is fine if you have an unlimited time frame,” he said. “But eventually, most people will have to start withdrawing from their nest egg, and when you’re withdrawing you lose the power of compounding.”

Aside from the fact that liquid alts tend to be more expensive, the rub on the category has been the performance lag when compared to broad market indexes and long-only strategies during bull markets.

The three-year annualized return of Morningstar’s market-neutral category, for example, is just 1.03%.

Even though alternatives are often sold as insurance policies against market declines, a 1% return is a tough sell when compared to three-year average equity fund category returns of between 6.76% for small-cap value funds and 10.61% for large-cap growth funds.

“Clients need to take a long-term approach about why you own liquid alts,” said Matt Harris, head of investment strategy at HighTower Advisors’ wealth management division.

“Investors will sometimes have to wait a long time to see the value in alternatives,” Mr. Harris said. “When things start to be difficult to hold or invest in, that’s typically when it’s the right decision to own them.”

Peter Lazaroff, co-chief investment officer at Plancorp Financial Services, appreciates the need for diversification through noncorrelated assets, but thinks most investors fail to grasp the nuances of alternative strategies.

“Everyone wants to find an asset that isn’t going to lose a lot of money when the markets go down, but the problem is expectations are way too high,” he said. “Clients don’t understand alternatives as much, and when the strategies don’t work as desired, the chances are they will get out at the wrong time.”

Todd Rosenbluth, director of mutual fund and ETF research at CFRA, said the unfortunate reality is that investors have become way too predictable when it comes to alternatives.

“Investors that think the recent volatility in the stock and bond market will persist into the new year may want to look to alternatives that generate more modest returns,” he said. “However, if the bull market resumes, these strategies will lag.”

Too often, that lagging performance hinders investors from seeing alternatives as noncorrelated portfolio diversifiers.

Key to keeping clients focused on alternatives as a diversifier is education on the front end, said Amit Dogra, chief executive officer of Third Seven Advisors.

“No doubt, we have seen people move money out of alternatives, but that just proves that you can’t time the market,” he said. “If you don’t have a tried-and-true strategy, you’re timing the market.”