Alts: A Great Story, But What Happened to My Downside Protection?

I’m blogging live from Financial Research Associates’ The Advisor & Broker-Dealer’s Forum on Retail Alternative Investments, where Bob Rice, managing general partner of Tangent Capital Partners, told attendees that it really matters which alternatives you’re in.

Rice agrees that alternatives make a great story with clients: They can reduce risk in the portfolio and increase returns. In fact, if you look at a 60/40 portfolio over a 10-year rolling period, it lost money 25 percent of the time, Rice said. And now we cannot get enough of alternatives. The new common mantra has been one-third stocks, one-third bonds, and one-third in alternatives, he said.

But what happened to downside protection in 2008? In September, October and November of 2008, hedge funds were down almost as much as equities, Rice said. But global macro and managed futures worked well during the crisis.

What’s his explanation? Normally, “efficient markets” rule. In other words, the math behind the efficient markets approach does work; mean reversion does work. But in crisis, behavioral economics rule, as was the case in 2008. As we’ve written in these pages, the unprecedented happens all the time. And not every alternative strategy works well in crisis, Rice said.

Sure, they’re hot. Sure, they’re sexy. But advisors should not just all of a sudden throw their clients into any type of alternative investment, Rice said. To say the least. According to Rice, stocks drive 90 percent of the risk in a portfolio, and many alternative investments are equity-markets-based. “You can’t just allocate to alternatives and think it’s all going to be better,” Rice said. “It can be better, but it ain’t necessarily better unless you’re careful.”

You should allocate to alternative strategies that are both convergent, such as relative value or distressed; and divergent, such as global macro and managed futures. You also need income-generating alternatives, such as MLPs or REITs; smart beta strategies, such as private equity or venture capital; and real assets, such as art, gold or timber.

Rice said people are piling in to alternatives because it’s a buzz word, but it’s a scary thing. It can lead to misallocation and poor choices.

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