From 2005 through mid-2012, liquid alternatives have had cumulative total returns of 10.5%, versus returns of -0.5% for traditional hedge funds, according to “The FRC Encyclopedia of ’40 Act Alternatives”—a study from the Financial Research Corp. (FRC), a division of Strategic Insight. FRC defines liquid alternatives as hedge fund strategies in a ’40 Act structure, and these data exclude real estate investment trusts (REITs) and commodities. Moreover, ’40 Act alternatives have offered diversification benefits because of a reduced correlation with stocks, especially during the 2008-09 crisis. Finally, liquid alternatives have better liquidity and transparency when compared with hedge funds
Even though liquid alternatives posted modest returns, the asset class still offered diversification benefits compared with real estate and traditional hedge funds and brought much lower volatility than commodities. Only bonds fared better, but study authors emphasized that this was due to a “once-in-a-generation” prolonged cut in interest rates that fueled a boom in bonds.
Despite research indicating alternatives can help investors manage volatility, many advisers are still hesitant to use them. According to the FRC study, only 22% of the survey respondents use traditional alternatives with any regularity, and more than 55% use them rarely or not at all. “Alternatives generally confuse people,” Rob Martorana, study author and senior analyst at FRC, told PLANSPONSOR. “They know they want to go beyond bonds but they are confused.”
The study suggests a lack of familiarity is preventing advisers from adopting alternatives, although there is no clear pattern to their usage or neglect. For example, gold and precious metals were more popular than managed futures (27% use gold and metals “frequently” or “always,” versus 17% who use commodities/managed futures), despite evidence to suggest the diversification benefits of managed futures.
“It seems that both clients and advisers are sticking to the tried and true, regardless of evidence that new products may offer superior diversification,” Martorana said.
Respondents cited several challenges to using alternatives, with client familiarity being the top objection (54% reported this was “very challenging” or “extremely challenging”). Other top challenges included complexity (47%), client risk tolerance (47%) and fees (46%).
If an adviser can show clients how alternatives can help, they will learn to overcome objections, Martorana said. “And when advisers realize that alternatives can help them win new business, they start making time for education,” he added. “Slow and steady can be a good approach to education for both advisers and clients. It makes sense to start with a small position that helps long-term diversification of portfolios. Then, as clients and advisers become more sophisticated, they can increase the allocation and use more complex strategies."
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