ETF Trends
ETF Trends

For the better part of 25 years, I have worked closely with financial advisors regarding the use of alternative investments. I’ve found that the advisors who have the greatest success — i.e., satisfied clients who understand their investments and their results — utilize a thorough, thoughtful and regimented approach toward alternatives. Specifically, I see them do these three things:

  1. They clearly define each client’s investment objectives and research whether alternatives can help meet those objectives.
  2. If the answer is “yes,” they select alternatives they believe to be well suited to help meet those objectives.
  3. Once they decide to use alternatives, they make them a consistent part of the asset allocation process for that client.

I believe this is the right approach for several reasons:

  • The advisor has a well-defined rationale for using alternatives that links their use to specific investment objectives.
  • The advisor gains a realistic understanding of what to expect from the different types of alternatives, especially with regard to performance. Given the unique nature of alternatives, it’s critical for advisors to understand what drives performance, and what to expect during different parts of the market cycle.
  • Once the decision is made to add alternatives, the advisor makes alternatives a core part of their long-term investment process for that client. As a result, the advisor avoids performance chasing. One of the biggest benefits of this approach is that it ensures that alternatives are included in the portfolio in anticipation of different parts of the market cycle, where they may be able to provide a diversified return stream when stocks and bonds may be under pressure.
  • Importantly, this process allows the advisor to have effective conversations with their clients in which they explain why they are using alternatives and how the use of alternatives can help meet the client’s investment objectives. The advisor can also set realistic expectations about what the client should expect from the alternatives selected.

The other side of the coin: The ‘dabbling’ approach

Just as advisors who successfully use alternatives share similar characteristics, I have found that advisors who struggle with alternatives tend to have similarities as well. Specifically, these advisors often lack a regimented approach and fall into the trap of dabbling. By “dabbling” I mean they often add alternatives based largely on recent performance and/or add alternatives in a random fashion that fails to link the use of alternatives to meeting specific investment objectives.

The dabbling approach often yields disappointing results for a few key reasons:

  • By not developing a well-defined rationale for using alternatives, the advisor tends to fall into the trap of allocating based on recent performance, which can pose the considerable risk of investing at unattractive levels where downside risk is greater than upside potential. This risk is especially pronounced for alternatives that have cyclical performance, such as managed futures, in which periods of strong performance are often followed by periods of decline. Furthermore, when investing based on a backward-looking view, the advisor runs the risk of “fighting a previous war” rather than preparing for future challenges.
  • Having failed to thoroughly research and understand the unique nature of the alternatives in which they are investing, advisors often fall into the trap of evaluating the investment based on short-term performance — perhaps even quarter by quarter. By doing so, the advisor ignores the various benefits that different kinds of alternatives may deliver over the longer term. Various alternatives may provide returns that are unique relative to traditional stocks and bonds, outperform during different parts of the market cycle, reduce portfolio volatility or provide important diversification.
  • From the client’s standpoint, the advisor does not provide a rationale that links the use of alternatives to the client’s investment objectives and does not provide the client with realistic expectations of how the various alternatives are expected to perform. As result, the client’s satisfaction with the alternative becomes based on short-term performance, often the relative performance vis-à-vis equities.

Clearly there is no one approach that guarantees success when implementing alternatives in investor portfolios. That said, in my view, the odds of success (satisfied clients who understand their investments and their results) increase dramatically when a thorough, thoughtful and regimented approach is taken, while the odds of success decline significantly when a dabbling approach is taken.

For more information about alternatives

Important information

Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.

Asset allocation/diversification does not guarantee a profit or eliminate the risk of loss.