Alternatives--Beyond Long/Short

Alternative investments are becoming more and more important to advisors. The Morningstar Barron's 2011 Alternative Investment Survey found that nearly 65% of advisors believe that alternative investments are as important as or more important than traditional investments. It also found that most advisors gain access to alternatives through exchange-traded funds or mutual funds. But there are so many options out there that knowing how to get started can be challenging.

To shed some light on this growing area, Nadia Papagiannis, director of alternative fund research at Morningstar, sat down with three alternatives experts: Christian Wagner, Thomas Platt, and Sean Clark. Wagner founded Longview Capital Management and serves as the lead manager on Longview Global Allocation LONGX, Longview Dynamic Large Cap SMA, Longview Fixed Income SMA, and Longview Tactical Commodity SMA. Platt serves as the national sales manager for Capital Wealth Planning, an independent fee-based registered investment advisor out of Naples, Fla., managing approximately $310 billion in covered-call strategies. Clark is CIO of the independent advisory firm Clark Capital Management, where he is responsible for asset allocation and investment selection. All three panelists run managed ETF portfolios incorporating different flavors of alternative strategies.

Investing in Commodities
One commonality among the three panelists was their sizable allocations to commodities. Wagner, for example, runs a global tactical asset-allocation strategy that includes commodities as well as a stand-alone commodity strategy that has both strategic and tactical positions. His team uses core index products for broad-based commodity exposure, although he pointed out that these do tend to provide excessive energy exposure. He will also invest more tactically by making specific bets on particular commodities expected to fare well in the current market environment.

Clark allocates roughly 25% to 35% of his portfolio's alternative sleeve to commodities. This part of the portfolio typically includes strategic positions in gold, which he believes acts as both a currency and a commodity (through its store of value). Clark expects gold to move appreciably higher in the intermediate term as countries continue devaluing their currencies to become more competitive on a global scale and as investors continue to lose confidence in central banks. He has increased his position accordingly. 

Volatility as an Asset Class
Another hot topic among the panelists this morning was volatility. Participants in a 2011 survey by Cogent cited volatility as their number-one investment concern, far ahead of both retirement planning and college savings. While the S&P 500 Index has steadily trended upward over time, huge volatility spikes interspersed along the way have burned investors time and again.

One way to hedge against this tail risk is by taking positions in volatility. Clark blends this asset class into his portfolios using different VIX products, which help him to protect asset values over time regardless of the market's direction. For an all-equity portfolio, he will be anywhere from 5% to 20% invested in volatility.

Wagner holds a slightly different view of volatility, namely that it is not an asset class because it has no intrinsic value. That distinction certainly doesn't detract from its practical value as an alternative trading tool, though. Wagner also pointed out that because the demand for implied volatility hedges is at its highest historical level, these VIX products will continue to be expensive. This presents a drag to an investor's portfolio, so it doesn't necessarily make sense to be strategically invested in these tail-hedging products.

However, there are ways to benefit from volatility without using VIX products. Platt, for example, writes monthly covered-call options, typically 8% out of the money, on ETFs. These options become much richer and the premiums more attractive when volatility spikes. While the current environment hasn't been great for covered-call writing, the strategy has helped generate income for his clients.

Cleaning House
One final note agreed on by all three panelists was that the current marketplace is saturated with ETF products. This is due in part to the "first-to-market" advantage, where the second entrant to a particular strategy might as well be the last. Providers have rushed to launch products during this ramp up, and Platt expects to see an overall contraction of products as smaller ETFs are forced to shutter.