Don't get drunk on liquid alternatives

In an environment of record-setting equity markets and most areas of fixed income no longer providing attractive risk/return characteristics, liquid alternatives have become the asset class du jour.

But just as with a bottle of fine wine, too large a swig of liquid alternatives can get investors drunk and prevent them from maintaining their balance.

Both the bottle of wine and liquid alternatives can get better with age, but the onslaught of new funds being brought to market daily and the overwhelming media response to liquid alternatives requires a thorough understanding of this diverse asset class before you become a collector for your investment portfolio.

fine wine
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Alternative investments are typically defined by what they are not: They are investments that have little to no, or even negative, correlation to investments in stocks, bonds and cash. In the past, these investments were predominantly hedge funds and private equity funds, accessed through limited partnership interests and usually for the ultra-high-net-worth investor who can qualify under the Securities and Exchange Commission as a "qualified accredited investor."

Those investments can be illiquid and lack transparency compared to new "liquid alternatives," which are being offered with the accessibility, governance and liquidity of mutual funds. Today's liquid alternatives are also pitching returns that are not based solely on long-only investing in stocks and fixed-income securities.


The absolute-return knowledge gap

A long-only investment approach provides an investor positive returns only if the securities increase in value and outperformance is typically measured against a broadly used benchmark to determine the success of the investment (i.e., the S&P 500 index for stocks or the Barclays Bond Aggregate Index for bonds).

Alternative investments, on the other hand, allow for shorting of stocks and/or using leverage and derivatives and access less familiar asset classes to construct the portfolio.

Alternative investments seek absolute returns that are focused more on profitable trades and positive performance, regardless of how underlying markets are performing. This does not mean, however, that they will always provide positive performance; rather, it implies that their performance is not tied to a typical benchmark.

Read MoreAlternatives add diversity, cut risk

This allows portfolio managers the flexibility to focus more on their long-term conviction in the trades they make rather than comparing themselves to the short-term performance of a benchmark and allows for a potentially lower correlation to other asset classes.

This can be a struggle for investors who are focused purely on benchmark returns, as alternative investment managers are more focused on their long-term risk-adjusted performance. The goal is for investors to reduce the overall long-term portfolio risk and thereby reduce the effects of a market downturn. The beauty is for alternative managers to make money from market dislocations and provide more consistent returns over time.

"The liquid alternatives space is becoming more mainstream and is here to stay."

Historically, hedge funds have produced equity-like returns with approximately one-third to one-half of the volatility of the equity markets. Their slow-and-steady approach can add a lot of value from an asset-allocation perspective to a portfolio. That's in contrast to the equity markets, which experience large upside performance followed by extended periods of down performance, similar to that of the 2000s.

Alternative investments can provide investors with more confidence to "stay the course" in their portfolios when things go awry in the markets, as they have and will continue to do.

The key is to understand the purpose of adding alternative assets to your investment portfolio and having realistic expectations about how they are to perform.

How to navigate the markets
How to navigate the markets   

With the equity markets' upward trajectory in the past couple of years, it has been difficult for alternative investments to compare with the performance of the equity markets. But the real question should be whether you should expect them to be beating the equity markets.

I propose that you should not, as they are an asset class designed for slow and steady positive performance and to provide better downside protection should the current markets experience some moves to the downside, which typically happen by surprise and can be severe. Alternatives are not in a horse race with the equity markets.

Read MoreRisk-averse? Opt for options

One of the most important things to consider when examining this asset class is how many non-traditional investment styles can be thrown into this bucket and classified as "alternative."

With the onset of so many new mutual funds coming to market—this space is the hotbed for fund companies' marketing teams—investors must look under the hood and truly examine the investment approaches used in such alternative funds.

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Avoid a liquidity trap

Having multiple funds that take different approaches may be better than having one fund, as different market environments will benefit different investment approaches. This can also reduce manager risk within the asset class.

With the expansion of this world of liquid alternatives, structural elements of the fund itself must be examined to ensure that shortcuts that could undermine the potential benefits of adding this asset class during market downturns are not being taken.

Read MoreAn alternative to alternatives

The liquid alternatives space is becoming more mainstream and is here to stay. Understanding the benefits of adding the asset class to a portfolio to provide better risk-adjusted returns is only one leg of the stool.

They can and will lose money in certain environments. Further, looking under the hood to know what the managers' strategies are is paramount—rather than just investing because of the label "alternative." Make rational, thoughtful decisions before getting drunk on alternatives.