Morningstar Advisor - December/January 2010 - 32

Spotlight Alternative Investments Go Mainstream By Nadia Papagiannis They reduce risk, are easy to access, and are becoming cheaper. There’s probably a place for alternatives in your clients’ portfolios. The latest catchphrase in asset management is “alternative investments.” Ten years ago, the term floated among only the wealthiest investors, who put their money in hedge funds and private equity funds. Most average investors hadn’t even heard of such investments. For those who knew of them and wanted in, entry was strictly limited. Plus, the whole idea of alternative investments seemed a little suspicious. But today, some of the largest asset-management firms—Vanguard, PIMCO, iShares, and Franklin Templeton, to name a few— have opened the door to a host of alternative investments for mainstream investors. Companies such as Putnam, with its lineup of new “absolute return” funds, have launched aggressive advertising campaigns to promote their alternative funds. The average investor can no longer ignore alternatives, and neither can his advisor. So, what should advisors make of these funds? Are they simply overpriced gimmicks, or do they deserve a serious look? Here’s an overview of what alternative investments are, who’s buying them, and how the right ones can have a place in many investors’ portfolios. Alternatives Defined a typical stock or bond. In terms of asset class, an alternative investment could mean real estate, commodities (and stocks with exposure to them), currencies, Treasury Inflation-Protected Securities, convertible bonds, high-yield bonds, and emerging-markets stocks and bonds. “Alternative” also has been used to describe 130/30, absolute-return, long-short, marketneutral, short-selling, bear-market, and leveraged-long or -short trading strategies. Morningstar analysts say that alternative investments should attempt to accomplish two things: provide a positive risk-adjusted return over time (as any investment should) and have a low correlation to traditional stock and bond investments. The idea of an alternative investment is to diversify a traditional one—to reduce the risk while improving the overall risk-adjusted return. This diversification is achieved by using a different trading strategy (shorting and hedging) and different instruments (commodity futures and currencies) that provide a different risk/return profile than traditional investments. By this definition, many investments commonly labeled as “alternative” are, in fact, not. For example, 130/30 strategies aim to be 100% net long traditional exposure. That results in a near 100% correlation to investors’ existing stock and bond investments. Real estate investment trusts are another example. REITs are highly correlated to the overall stock market, because investors in REITs take equity stakes in an operating company. Furthermore, REITs are already included in the S&P 500, so a separate stake in REITs will not change a traditional portfolio’s risk/return profile. Similarly, stocks with commodities exposure act more like stocks, rather than the underlying commodities, and as borders open and trade increases, emerging-markets stocks are becoming more closely tied to the equity markets in developed economies. In contrast, true alternative investments— those that have a low correlation to a traditional stock/bond portfolio—will reduce or negate the losses in a portfolio. These include: Hedged Equity Today, people use the term “alternative investment” to mean almost anything that’s not Hedge-equity strategies invest in traditional stocks, but they hedge out some of the overall market risk by shorting other stocks, index ETFs, and index futures and by buying puts and writing call options (on individual stocks or indexes). The result is an investment that provides much of the upside but less of the downside of the stock market. The standard long-short or buy-write strategies fit in this category. A few hedged fixed-income mutual funds exist as well, but this strategy is difficult to carry out in a mutual fund or ETF format. 32 Morningstar Advisor December/January 2010

Morningstar Advisor - December/January 2010

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