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Alternatives: When, Why, and Which Ones?

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Many alternative investments for individual investors have proliferated over the past several years, but investors often struggle with whether to add them, and if so, which ones.

Here to discuss that question is Nadia Papagiannis. She is alternative investment strategist for Morningstar.

Nadia, thanks for being here.

Nadia Papagiannis: Thanks for having me.

Benz: So let's start with a general question. How do you define "alternative," because a lot of things get thrown under that broad umbrella?

Papagiannis: Everybody has a different definition, but at Morningstar, we define alternatives as investments that invest in different asset classes or different strategies, meaning they short or they hedge, and the result is their return profile is going to be different than traditional stocks and bonds. So it's going to kind of zig when stocks and bond return to zag, and that's the idea of lower correlation.

Benz: Right, so I'll confess. I come at this as a little bit of a skeptic. I'm wondering if you can talk about what you think alternatives add versus a portfolio that's composed of traditional asset classes like stocks and high-quality bonds.

Papagiannis: I would say the defining characteristic of an alternative investment is risk management, and that's something that's really not found in your long-only stock or bond funds, and managers can manage risk by shorting or by hedging, and what that accomplishes is a return profile that's probably not going to have as much of an upside, but it's going to have a lot lower downside. So over the longer term you're going to have it better risk adjusted return.

Benz: So you're saying that if you add an alternative investment to a portfolio that includes traditional asset classes, you'll reduce the overall risk profile.

Papagiannis: Right, and you'll improve the risk-adjusted return of the overall portfolio. And a lot of people think that they are sufficiently diversified with just stocks and bonds, and they look to 2008 when U.S. Treasury bonds did really well, and basically they were the only asset class that had positive performance in 2008. And so many investors came out of that thinking, well, I can just pile into Treasury bonds and then I'll be sufficiently diversified against another market crash.

Well, that's what a lot of investors have done, and in fact, lot of money is in Treasury bonds and corporate bonds right now. But there is a big risk in that right now, and the risk is that although Treasury bonds have done particularly well over the last couple of years, especially on the longer end of the yield curve, there's also been a lot of volatility in the longer end of the yield curve. So if you adjust for risk-adjusted return, you'll actually see that the average long short-fund has done better than the longer-dated Treasury since the market started to rally at the beginning of 2009.

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And so, what you have to think about in the case of alternative investments is not just the lower correlation aspect; you have to think about the long-term return potential. So, you want something that's going to hedge your downside risk, but also have the potential to give you positive returns over the long run--after all, why would you invest in something if you are not going to have positive return?

Benz: So, assuming that I like this concept of adding some alternatives to my portfolio and think that I can improve the risk-reward characteristics, how much of a portfolio should one think about dedicating to alternatives?

Papagiannis: Sure. There is a common misperception with alternative investments that if you're more conservative then you would have a lower allocation to alternatives, and in fact that's the opposite of the way it should be. If you are more conservative, you should allocate more towards alternatives because they are going to have a better downside risk protection than your long-only investments.

Now, in terms of specific numbers, we survey advisors every year as to what percentage of their portfolio they put their clients in, and increasingly we're seeing advisors go towards the greater than 10% allocation. So, it used to be that most advisors would be between 1% and 5%, or 5% and 10%, but now we are seeing more advisors in the 10% to 20% and over 25% even.

In the last survey more than 10% of advisors had more than 25% of their clients' portfolios allocated to alternatives. And that's actually moving in the direction of how institutions think about asset allocation. Institutions have traditionally invested 40% or more of their investments in alternatives because they see the potential for the overall improvement of risk-adjusted return of the portfolio by adding these investments.

Benz: So, one thing I want to touch on, Nadia, is the cost profile for a lot of these funds--especially the ones available to retail investors, sometimes they can be really high. So, if you looking at return projections for some of these categories that might be, I don't know, in the neighborhood of 6% or something like that, it seems like a bad bet to pay 2% a year for that kind of return. What's your take on the importance of costs when looking at these investment types?

Papagiannis: Sure. The average expense ratio in the long-short category is about 2%, and that's significantly higher than the average long-only stock fund. What you're getting with that 2% is you're getting risk management. You are getting the management expertise and also the operations required for risk management--so, the traders, the compliance, the risk management personnel, that kind of thing.

That said, the more funds that come into this space, I believe that the costs are going to go down, and so I think that it will only be better for investors, in terms of options and in terms of expenses over the next few years.

The kind of funds you want to avoid are the funds of funds--I'm not saying you should avoid all funds of funds--but the funds of funds tend to have the highest expense ratios, and that's because you're layering on several fees on fees, and that's when you're starting to get into well, is my return going to justify this "fees on fees." And that's the case for really any funds of funds, but especially the funds of funds that are perhaps going to outside hedge fund managers, and hedge fund managers are charging a higher management fee, that kind of thing. You might be wary of those types of funds, because it might be higher hurdle to eclipse if you're trying to get a return.

Benz: Okay. So those are the funds I should avoid. How about a couple of alternative funds that you really like--maybe let's start with one that you think is a truly defensive type of alternative offering?

Papagiannis: Sure. One fund, the Hussman Strategic Growth Fund, is actually a Morningstar Analyst Pick, and he has been around since the earlier part of the decade. And while his returns haven't been spectacular the last few years, John Hussman is really good at preserving wealth, so while he hasn't made a lot of money for investors over the last few years, he really hasn't lost it, either. So if you're looking to take on some equity market risk but you are kind of wary about where the stock market is going, I would choose John Hussman's fund.

Benz: Okay, and then more aggressive option?

Papagiannis: Sure. One of the newer funds that has come out this year is called Forward Tactical Growth Fund. This fund is more of a macroeconomic, can take on different levels of market exposure based on their macroeconomic outlook, and while it's a newer fund, it has had pretty decent returns, and it has actually raised a decent amount of money over the last few months. So it's not a tiny fund that investors might be scared of.

Benz: Well, Nadia, thanks for sharing your ideas on this category. We appreciate it.

Papagiannis: Thank you, Christine.

Benz: Thanks for watching, I'm Christine Benz for Morninstar.com.