Alternative investments were once the provenance of institutions and ultrahigh-net-worth investors who have the resources required to invest in hedge funds, private equity and other rarified securities that offer diversification and low correlation to equities and fixed-income investments. Today, however, investing in alternatives has become more widespread among individual investors. In fact, more than half of financial advisors consider alternatives to be as important as or more important than traditional investments, according to a 2013 survey by Morningstar.
Investor behavior and alternatives
The average individual investor generally lacks the skill to match market returns—let alone exceed them. Research from DALBAR’s Quantitative Analysis of Investor Behavior shows that these investors lag the market significantly. In 2013, for example, individual investors in equity funds earned an impressive 25.54% return—yet that figure substantially trails the performance of the broad market as measured by the S&P 500, which returned 32.41%.
DALBAR’s research attributes this poor performance to individual investors’ tendency toward market timing: Investors tend to sell well after a paper loss, and wait to re-enter the market until well after a recovery is underway. These tendencies can be challenging for advisors, who must counsel clients to stay the course through periods of volatility and, at times, significant investor trepidation.
Adding an allocation to alternative investments may help clients to weather volatile markets more easily: The knowledge that their portfolio is specifically designed so that a portion of it produces gains in down markets may make it easier for clients to sleep at night.
A place in the portfolio
In general, the current state of the markets is driving broad demand for alternative investments. Put simply, a portfolio that solely consists of publicly traded assets may not provide the returns that individual investors seek. “In today’s low interest rate environment, you see many investors lengthening duration and cheapening credit quality to improve their real rate of return,” says Frank Muller, executive vice president and head of distribution at Behringer. “Whereas, if they started to look at private equity and private debt, they could be doing the exact opposite—shortening duration, improving credit quality, and achieving better risk-adjusted returns than they could in the public markets.”
That’s because alternative investments traditionally have a low correlation with standard asset classes. This kind of diversification is difficult to find, as globalization is resulting in increased asset correlation. Investors are in the difficult position of seeking enhanced portfolio diversification during a time when achieving it is harder than ever.
Furthermore, as baby boomers begin to enter retirement, they’re spurring demand for retirement income solutions that have the potential to provide higher risk-adjusted returns, but which also offer the kind of diversification that’s crucial for a secure retirement. Including alternatives in a portfolio is one way to do that.
Risks and rewards
Alternative investments do come with some downsides, of course. They tend to be less liquid than traditional stock-and-bond investments. They also typically carry higher fees than many traditional investments. Since 2009, alternative investments have lagged well behind the S&P 500—which is no surprise, since alternatives are generally negatively correlated with public debt and equity asset classes.
But for some clients, the benefits may likely outweigh the shortcomings. “There’s a yin and yang to everything,” Muller says. “If you desire liquidity, you incur volatility — and vice versa. Investors have to be compensated for illiquidity, something that’s called the illiquidity premium. The increase in returns over a long period of time could be quite significant. So, in this sense, illiquidity can be a virtue—to the extent that it fits your age and financial goals.”
More Information for Financial Advisors
To find out more, download the informative white paper, “Diversifying with Alts: Constructing Portfolios that Reduce Volatility and the Likelihood of Fear-based Selling,” available at behringerinvestments.com/evolve. This resource helps Financial Advisors hone their expertise in using alternative investments to potentially improve long-term returns by mitigating the effects of volatility, which could tempt investors to do the wrong thing at the wrong time.
Diversification does not ensure a profit or guarantee against a loss. Past performance is neither indicative nor a guarantee of future results.
For educational purposes only. This material is neither an offer to sell nor the solicitation of an offer to buy any security, which can be made only by the applicable offering document.
 “2013-2014 Alternative Investment Survey of U.S. Institutions and Financial Advisors,” Morningstar/Barron's, July 2014.
 “Quantitative Analysis of Investor Behavior 2014,” DALBAR, Inc. www.dalbar.com