Alternative Investing

As alternatives go mainstream, investors scratch their heads

Alternative investments are coming to the masses, but is that a good thing?

The term "alternative investments" is broadly defined as alternatives to traditional investing approaches—such as stocks, mutual funds, long-only stock holding and bonds—and it covers a lot of territory.

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According to Morningstar, alternative investments fall into three camps:

  1. Nontraditional asset classes, such as currencies and commodities.
  2. Nontraditional strategies, such as shorting and hedging (in both traditional and nontraditional asset classes). [See information box below.]
  3. Illiquid assets, such as private equity or private debt.

The most recognized type of investment in this category is the hedge fund, known for its high fees, funds lock-up and sometimes mysterious investment strategies—and available only to high-net-worth investors or institutions.

Read MoreNo, you don't 'need' alternatives

However, since 2008, alternative strategies have been developed for common investors in public, regulated, liquid structures, such as mutual funds or exchange-traded funds, according to Morningstar.

These liquid structures have come to be known as "liquid alternatives," and they are in the midst of an explosion aimed at the retail investor.

Common 'liquid alternative' mutual fund strategies

  • Bear market
  • Multicurrency
  • Single currency
  • Long/short equity
  • Market neutral
  • Multialternative
  • Managed futures
  • Volatility
  • Trading (leveraged commodities, inverse commodities, leveraged debt, inverse debt, leveraged equity, inverse equity, miscellaneous)

Source: Morningstar

Liquid alternatives boom

According to a 2013 Goldman Sachs report, "retail liquid alternative products … are in the early stages of a 5- to 10-year growth trend …capable of producing a $2 trillion [assets under management] opportunity."

Between 2008 and 2014, the number of alternative mutual funds and ETFs has grown from 482 to 1,569, while net assets have grown from $42.6 billion to $309 billion, according to Morningstar.

But the concept of alternative investments is complex and is not easy to wrap one's head around.

"Should the average investor have exposure to alternative investments? Yes and no," said Douglas Kobak, certified financial planner and principal of Main Line Group Wealth Management. "'Alternatives' is such a nebulous word, and it encompasses so many strategies."

Michael J. Anderson, CFP and vice president of financial planning with True North Advisors, said, "We don't like the term, because clients don't understand it—the definition varies."

For his part, Barry Glassman, CFP and president of Glassman Wealth Services, said that "a lot of advisors are looking to use alternative investments, but … what's missing from the picture is the clients' level of understanding of what they own and what that investment is trying to achieve."

Nonetheless, the use of liquid alternatives is taking hold. According to a Morningstar report, about 60 percent of advisors allocate between 6 percent and 20 percent to these products. The top drivers listed in the report are:

  • diversification/low correlation
  • enhanced risk-adjusted profile
  • absolute returns
  • poor bond market outlook
  • investments clients wouldn't find on their own
  • enhanced yield
Alternative investing in 2015

There is also a behavioral benefit associated with the use of liquid alternatives.

"For the most part, these funds are not going to be a panacea for all market conditions and won't generate hedge fund-like returns depicted in pop culture," said Adam J. Reinert, CFP with the Marshall Financial Group.

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"However … by looking at these funds just as a piece of the entire portfolio, it may help the portfolios generate lower volatility during turbulent times and, in turn, allow the investor to fight off the behavioral urge to sell at market bottoms."

Reinert's firm uses alternative-strategy mutual funds to reduce portfolio volatility and increase portfolio diversification.

Wait and see

Reinert has a wait-and-see attitude toward the rapid proliferation of liquid alternatives.

"While this [growth] adds more options to the space, it also means that there are more funds that might not have proven track records," he said. "One benefit, though, is as more funds come to the market and compete for the same dollars, investors should benefit from lower overall fees in the space."

Some advisors are not fans, however.

"I'm arguing completely against liquid alternatives because they don't add value to justify the fees they charge," said Marcio Silveira, founder of Pavlov Financial Planning. He is a CFP and also holds the Chartered Alternative Investment Analyst (CAIA) designation.

Read MoreWeigh feisty bond alternatives

In fact, liquid alternatives as a whole have not kept up pace with the .

According to Morningstar, as of Nov. 30, the average alternative performance had a .540 percent annualized three-year total return vs. 20.925 percent for the S&P. The five-year figures were -0.892 percent and 15.955 percent, respectively.

"The recent growth of liquid alternatives is essentially driven by aggressive sales efforts of Wall Street," Silveira said. "I feel that since the institutional investor/high-net-worth market is saturated, that's why they're making these products available to retail investors."

"The level of complexity is hard for both financial advisor and client," he added.

Alternatives are doing things that don't have standard benchmarks; you have to rely on the salesperson.
Douglas Kobak
principal of Main Line Group Wealth Management

Lack of transparency and benchmarks are also issues.

"Alternatives are doing things that don't have standard benchmarks; you have to rely on the salesperson," said Main Line Group Wealth Management's Kobak, who manages clients' alternative ETFs using his own proprietary approach. "And when there's no transparency, it's hard for people to keep their hands on the pulse of what they have."

Anderson at True North Advisors is not concerned with whether a product is labeled alternative or not, but what function it serves in a portfolio.

"We are product/structure nonbiased as the prism we evaluate invests through," he said. "What it really comes down to is liquidity [or not], transparency [or not], diversification (or not) and through [due] diligence whether the reward is worth the evaluated risk of the particular investment."