Potholes and Opportunities in Alternative Investments

Morningstar and Barron's ninth annual survey of perceptions and usage of alternative investments sheds some much-needed light on decisions taking place at advisory firms and intuitions. (The survey was conducted in the spring of 2015 and covered the 2014 period.) For several years, alternative funds have benefited from recurrent financial market concerns. As investors have at various times agonized over possible stock market corrections or an end to the 20-plus-year bull market in bonds, they’ve often reacted by piling into alternatives. More recently, though, as the bull market has continued largely unabated, investors seem to have become more sanguine about the markets, or perhaps less content with missing out on the upside. Our survey helps get at the motivations behind the flow trends and offers insight into where the opportunities and potholes may lie for the alternatives industry and those who invest in these products.

Investor Returns Leave a Lot to be Desired While mutual fund investors are known to make poor timing decisions, the data for alternatives show several disturbing trends. Long-short equity fund assets, for instance, have grown almost fivefold since 2008, as investors were attracted to the category's relatively superior performance during the financial crisis--the category dropped only 15.4% while the market had a 37% pullback. While the category does offer investors better downside protection than long-only vehicles, the funds, as expected, haven't kept up as well during market rallies. The funds have lagged the market by an astounding 11.5 percentage points per year from 2009 through June 2015, while only beating the Barclays US Aggregate Bond Index by 0.2% over the same time period.

There are other examples of poor market-timing. In 2013, investors poured $55 billion into non-traditional-bond funds, in part to protect against anticipated rising interest rates, a move that hasn’t proved fruitful so far. Also, we’ve witnessed a fair amount of performance-chasing over past few years as investors poured $13.4 billion into

Advisors Still Positive, While Institutions Waffle Given the performance challenges, we had anticipated a possible decline in interest around alternatives investments. While that was the case for institutions, advisor interest actually increased, as advisors anticipate that their alternative allocation will continue to increase. In 2014, 63% of advisors allocated more than 11% to alternatives, compared with 39% for the previous year. Most advisors (59%) allocate between 6% and 20% to alternatives.

But institutional sentiment declined slightly from previous years, especially at the extreme levels. For example, institutional respondents who said they expect to allocate more than 25% to alternatives declined to 18% from 31%. Similarly, institutions that currently allocate more than 40% to alternatives saw a steep decline, to 9% in 2014 from 18% in 2013. Moreover, 45% of institutions stated that alternatives were "somewhat less important" or "much less important" than traditional investments, as compared with 28% in 2013.

A number of factors could be behind these shifts. First, institutions likely allocate more to hedge funds than to liquid 1940-Act mutual funds, and hedge funds have faced their own set of challenges. While alternative mutual funds are still growing at a healthy clip, assets in Morningstar’s single-strategy hedge fund database (a representative sample of the hedge fund universe) actually fell slightly from 2013 to 2014. The survey found that institutions were concerned with high hedge fund fees, lack of liquidity, and poor transparency. We also found that institutions weren’t affected by CALPERS’ decision to exit the space (or at least were not willing to admit it). But there may be other factors at play as well. Institutions have also been ahead of the curve, compared with advisors, in using alternatives, and perhaps they’ve reached a saturation point and are now starting to pull back.

In light of the shifting tides of sentiment, it was reassuring to see that both institutions and advisors continue to cite diversification/low correlation as their top reason for investing in alternatives, and by a wide margin. That provides reassurance that the gatekeepers for these products understand their role in a portfolio.

Multistrategy Funds Get a Boost Morningstar's multialternative category has garnered a lot of attention lately, as flows into the space have topped $9 billion per year over the past two years. These funds are meant to serve as a "core" alternative holding (a bit of an oxymoron) or as a one-stop-shop for alternative exposure. Given that investors appear to be struggling with timing certain alternative allocation decisions, these funds seem like a potential remedy. Institutions cited multistrategy funds as the fastest-growing part of their alternative allocations over the past five years, as well as the top strategy for increased allocation. On a similar note, advisors rated multistrategy/fund of funds as the third-fastest grower, behind MLPs and other alternative strategies.

That institutions may be more interested in multialternative funds than advisors is somewhat surprising, given that many of these products are tailor-made for advisors. Generally, institutions have more investment personnel and have the resources to build out a dedicated alternative fund selection team. So, one would expect institutions to build their own array of custom alternative portfolios and for advisors to clamor for multialternative funds.

Perhaps the survey demographic data can shed some light on this quandary. The data show that 58% of institutions that participated in the survey have less than $11 billion in assets under management, while 38% have less than $1 billion. So, it might be reasonable to conclude that many of our respondents have fewer resources than the very largest institutions but have the desire to include alternative allocations. Multistrategy funds would thus be an ideal choice if an institution doesn’t have a dedicated alternative fund selection team but does has the drive to invest in alternatives. Meanwhile, it seems that advisors are somewhat behind the alternative allocation curve and are catching up to institutions by allocating more to alternatives.

Picturing the Ideal Client for Alts As part of our annual set of new "hot topic" questions, we asked both advisors and institutions to picture the ideal client for alternative investments, on five different dimensions (client sophistication, distance from retirement, level of assets, level of required return, and level of risk tolerance). The results gave us a window into the necessary criteria financial professionals look for in order to decide if alternatives are suitable for a particular client. Both groups agreed that, for clients to be considered optimal for an alternative allocation, a higher level of sophistication and a higher asset threshold were required. But interestingly, the group also agreed that clients should be midway through their careers and not too close to retirement. While these results aren't shocking, it does show that alternatives still carry a stigma of riskiness, in that respondents believe they aren't appropriate for a client near retirement. Given that alternatives actually tend to be somewhat less risky than stocks and that there are also decent fixed-income alternatives worth considering, this stereotype might be worth trying to break.

In terms of required return and risk tolerance, both advisors and institutions agreed that about average required levels of return and average levels of risk tolerance were ideal for considering adding alternatives to a client’s portfolio. The data shows that alternatives probably aren’t suitable for very conservative clients, nor are they acceptable for clients seeking high-octane returns.

A Slowdown Ahead? The survey highlights some astonishing trends at a time when alternative flows are starting to moderate. While organic growth rates for liquid alternative mutual funds during 2014 are still larger than any other broad Morningstar Category, they were the slowest on record since 2008, at 12%. But the survey shows that advisors aren't all doom and gloom and may be looking to allocate more into alternatives over the next couple of years. But the pace at which institutions appear to be withdrawing from alternatives does raise an eyebrow. It's possible that many of them are abandoning certain less-liquid strategies, and therefore their allocations into liquid alternative mutual funds might actually stand to increase. We have heard anecdotally that, although just a trickle so far, more institutions are taking advantage of liquid alternative strategies when offered as a reasonable version of an existing investment. Regardless of how this plays out, it's worth paying attention. Are liquid alternatives now a more mature asset class (and therefore will exhibit slower growth), or will flows pick back up again if market volatility increases? While the tea leaves are a bit murky, the magnitude of new fund launches by fund companies indicates that the smart money is on these products continuing to take in sizable flows.