In a world where many investments seemingly move in lock step, some are now suggesting that average people consider buying alternative investments that were once the preserve of only the most sophisticated investors.
The reason is that these investments -- which come with such exotic names as long/short, merger-arbitrage, market-neutral, and inverse bond -- can help boost the risk-adjusted return of a portfolio in ways that a traditional stock, bond and cash portfolio can no longer do. The idea is that adding such investments will provide average folks with downside protection increasing the potential for increased returns.
But those recommendations raise plenty of questions. Is this really a good thing for average investors to do? Goodness knows that we've witnessed the ill effects of the democratization of many other financial investments.
Mind you, we're not talking about so-called accredited investors, those ultra-rich investors who buy mostly illiquid investments such as hedge fund limited partnerships, managed futures funds, and private equity. Rather, we're talking about the hundreds of plain vanilla alternatives that are now available as ETFs and mutual funds, with daily or near-daily liquidity.
Rob Isbitts, CFS, the founder and chief investment strategist of Sungarden Investment Research says he thinks alternatives can be a wise decision. "In my opinion, stocks bonds, and cash do not provide adequate diversification in today's market environment," he wrote in his book, "The Flexible Investing Playbook: Asset Allocation Strategies for Long-Term Success."
"Alternatives are an alternative to the classic stock-bond portfolio," he said.
Others agree. "We need to educate investors about confronting the growing gap between needs and resources for retirement," Laurence D. Fink, the chairman and CEO of BlackRock, said in a speech last week. "That means getting investors beyond the now inadequate 60/40 portfolio mix of stocks and bonds." And that includes looking at alternatives.
But Isbitts said in an interview (as well as in his book) that investing in alternatives must be done in a prudent and well-planner manner, not just by adding a pinch here and a dash there.
You have to know the desired outcome, and how adding alternative investments or what he called a hybrid strategy will help you reach your investment objectives. You don't want to "cherry-pick off a list of top performers," said Isbitts, who was quick to note that there's way too much of that going on.
"The concrete, quantitative objective of the hybrid strategy is to produce a consistent stream of absolute returns with low market correlation over a minimum rolling three-year time period," wrote Isbitts, who offers advisory services through Dynamic Wealth Advisors.
"Many people do not want to see tremendous fluctuation in the possibility that they will achieve their desired lifestyle. It follows, then, that their portfolio should be designed to keep fluctuation in value low, while still maintaining the potential to grow at a competitive rate."
According to Isbitts, the hybrid or alternative investment strategy has three specific objectives: It pursues consistent positive returns with low volatility as measured by beta; it succeeds with less dependency on the market itself, or what investment professionals call R-squared; and it shrinks the range of possible outcomes, or what is also known as standard deviation.
In other words, it's about a having a good offense and an even better defense. Yes, it might mean sacrificing some of the equity market's upside. But it also means being better positioned for market declines. "While all of the strategies I have created over the years aim for this outcome, hybrid is the one most vigilant against market risk," wrote Isbitts.
As with institutional investors, the objective for retail investors is to enhance risk adjusted returns and to protect against shocks, Matt Botein, head of BlackRock Alternative Investors, said in an interview. And alternatives can help do that.
Isbitts said, "You want to manage beta, manage volatility, but do it by having target volatility level for a particular market circumstance. And it's all a bit relative. So, for instance, a conservative portfolio today might be between one-third and a half the expected volatility of the stock market. There may be other times when that same portfolio might be close to zero volatility."
And that's the idea behind adding alternatives. "There are several asset classes that have stock-like and bond-like qualities and/or they have a way to mitigate some risk of equity market," Isbitts said in an interview.
So, given that this notion of investing in alternatives is, at least for some, a good idea for non-accredited investors, then these questions must be answered: Which alternatives? How much might one allocate toward these investments, 5%, 10%, or more? And can you really do this on your own, or do you really need the help of a qualified financial adviser?
According to Isbitts' book on the subject, the universe of alternative investments appropriate for average investors includes long-short, a strategy involves going long and short, with some but not a lot of leverage; market-neutral, a long-short strategy with an emphasis on keeping the longs and shorts close to even; merger-arbitrage, a strategy that provides an opportunity for consistent upside with built-in protection; convertible securities, which offer the upside potential of the underlying stock, but with the safety net of a bond; high-yield bonds; dedicated short equity or bear funds, which largely move in the opposite direction of the market; inverse bond, which move inversely to the direction of bond market; global macro, which look like flexible hedge funds in a mutual fund package; currency funds, and real-estate investment trusts. (Read Isbitts' commentary about alternatives at this website.)
As for how much to invest in alternatives, Isbitts is more in the all-in camp than the toe-dipping camp. In fact, given his prediction that interest rates are more likely to rise than fall over the next few years, he recommends replacing the bond portion of your portfolio with a mix of alternative investments. "Instead of stock-and-bond portfolio you'd have a stock-and-hedge portfolio," Isbitts said.
According to Isbitts, alternatives investments represent a suitable alternative to bond funds and bond-managed accounts, target-date funds, balanced portfolios, and conservative hedge funds and hedge-funds-of-funds.
"A central tenet to hybrid investing is that the combination of funds owned will have several natural offsets to each other," Isbitts wrote in his book. For instance, owning a dedicated short equity or bear fund neutralizes the risk of an all-stock portfolio. Using arbitrage and market-neutral funds reduce the impact of stock market movements. And having currency and inverse bond funds offset the exposure to interest-rate-sensitive investments in the portfolio.
For those who might want a more conservative portfolio with alternatives, Isbitts suggested using merger-arbitrate, currency, market-neutral and dedicated short equity funds. And for those who want a more aggressive portfolio, Isbitts suggested using global macro, high yields, convertibles, and long-short funds.
Botein said investing in alternatives requires the help of a financial adviser, and thinking about such investments as part of the whole. "You can't think of alternative investments as homogenous, under the same umbrella," Botein said. "They don't all behave the same; some in isolation are risky, but taken together they improve risk return."
Isbitts also warned against not having a sound strategy before investing in alternatives. "Everybody wants to be a full alternative investor but what they do is they end up buying products that are sold to them," said Isbitts, who noted that financial services firms are fond of promoting a full suite of alternative products these days. "Alternative to what?" he asked. "It's not an alternative if you are exchanging mediocrity for mediocrity."