FA Playbook

Alternatives can add diversity, reduce risk in any investor portfolio

Alternative investments, which are no longer just aimed at the uber-rich, can bring significant benefits to an investor's portfolio by diversifying risk exposure away from traditional fixed-income and equity assets, some financial experts say.

In fact, many financial advisors are introducing average retail investors to a wide range of alternative asset strategies.

I spoke with Ed Butowsky, managing partner at Chapwood Investments, to get his take on using various alternative investment strategies in a client's portfolio. Butowsky, who has been in the financial services industry for more than 25 years, was featured in the film "Broke," an ESPN "30 for 30" documentary chronicling professional athletes and their monetary experiences.

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CNBC: Ed, can you give a basic overview of alternative investments? What constitutes something that's defined as an alternative?

Ed Butowsky: The term alternative investment has become synonymous with any investment that's not directly associated with the up-and-down movement of the stock market. It's basically an investment in asset classes other than stocks, bonds and cash. The goal of investing in alternatives is to reduce the overall downward value of the portfolio during stock market retractions.

CNBC: What are the various risks when investing in alternatives?

Butowsky: Every investment as a stand-alone has some risks. They could have capital risk, purchasing power risk, inflation risk or reinvestment risk. The reason investors include alternatives in portfolios is to add a "different" type of risk, which in practice should reduce the overall risk of the portfolio and hopefully position them to be able to weather most economic conditions.

Read MoreAlternatives: Not so scary

Having said that, it's been well reported that investors have become somewhat frustrated with various alternative investment strategies. So when "alts" aren't matching or beating the returns of the , inherent amnesia sets in and investors forget that they invested in alternatives because they have a different risk agenda than stocks and bonds.

That's why investors need to know what alts are there to do. The biggest risk investors are taking now is not learning lessons from the history of investing that prove over and over again that all portfolios should contain investments that have different risks, i.e., alternative investments.

Windstream to spin assets into REIT
Windstream to spin assets into REIT

CNBC: Do the risks outweigh the rewards? If so, why?

Butowsky: I am a huge proponent of always having a portfolio that is prepared to handle different economic and market conditions. With alternatives, the risk isn't necessarily investment performance but ... investor performance. Most seasoned investors know that a properly managed portfolio should always have some investments that are not doing well relative to the others. If you have a portfolio where everything is going up at the same time, your portfolio is being mismanaged.

CNBC: With the rise of new liquid alternatives, advisors are presented with more options to include alternatives in their clients' portfolios. What type of investor is the right fit for liquid alternatives?

Butowsky: A liquid alternative, for the most part, is an alternative investment that has very favorable liquidity terms. One of the biggest drawbacks to alternatives has been long lock-up periods, so liquid alts were created to address those concerns.

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Basically, liquid alts are alternative investment strategies that are available through alternative investment vehicles such as mutual funds, exchange-traded funds and closed-end funds that provide daily liquidity.

I don't believe the size of the client's portfolio should dictate [whether] you should include alternative in a portfolio.

[Whether] you have ... $100,000, $1 million or $10 million, there should always be a percentage of your assets in alternatives. Liquid alternatives are a wonderful new entry into the investment choices that we have to offer clients. They were introduced due to the demand that retail clients had for liquidity, which was one of the biggest drawbacks previously to alternative investments.

I have learned that when you can't give away an investment and there is very little interest, it is usually the time to start buying.
Ed Butowsky
managing partner at Chapwood Investments

CNBC: How do you implement an alternative strategy into a client's portfolio?

Butowsky: We analyze the existing portfolio, focusing on correlations to the S&P 500 and search for alternatives that have three-, five-, seven- and 10-year correlation numbers that are low and trending lower.

We want to implement alternatives with combined "correlation statistics" that are 0.4 or lower to the S&P 500. I have been investing in alternatives since 1987, starting my career using managed futures to complement my long-only portfolios. I have learned that when you can't give away an investment and there is very little interest, it is usually the time to start buying. I have always been a fan of managed futures, and since I can't give them away right now, I am aggressively placing money in them.

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CNBC: What impact does the alternative strategy have on the portfolio?

Butowsky: The answer depends on the type of underlying assets in the portfolio. However, generally speaking, it should have very little bearing on the returns. Most hedge fund managers enjoy long lock-up periods so they can have predictable income streams, and some will argue that they cannot put on certain positions if they have liquidity concerns. This is true for some managers with certain strategies. But, generally speaking, having liquidity shouldn't impact the returns of a portfolio.