Morningstar Advisor - June/July 2013 - (Page 41)

Bradley Alford One thing each alternative asset class has in common is the ability to provide investors with insurance against declines in a 60/40 portfolio. Richard Raby The idea of buying and hoping the market will go up while witnessing 2000–2002 and 2008 is a little hard for many to handle. on stock- and bond-market exposure. It is getting more and more difficult for investors to meet their objectives with a traditional 60/40 stock/bond portfolio—equities keep rising but that can’t last forever, and bonds are a poor investment as the 30-plus-year bull market in interest rates comes to a close. I view alternatives as the necessary third component to a diversified portfolio. Alternatives can play many different roles in a portfolio, from return enhancer, to fixed-income substitute, to diversifier; one thing each alternative asset class has in common is the ability to provide investors with insurance against declines in a 60/40 portfolio. Combining non-correlated investments can create a portfolio with better riskadjusted returns. Raby: They are a means to mitigate downside risk, maximize risk-adjusted returns, and minimize correlation to the market. Bregman: Risk mitigation in the form of limiting overall portfolio volatility, for starters. Curtailing volatility can provide an investor with the opportunity to limit downward movements and position the portfolio for gains in the future. Kerns: How has the environment changed over the past 10 years for alternative investing? Alford: I have been investing in alternatives for more than 20 years, so I have witnessed an incredible amount of change, but especially in the past 10 years. There has been a mainstreaming of alternatives, particularly due to the availability of liquid alternative mutual funds. Ten years ago, alternatives were confined to the biggest institutions, but they have now become an accessible component of a diversified portfolio for all investor types. Raby: People have opened up to the use of alternative, hedged, and flexible strategies a great deal more. The idea of buying and hoping the market will go up while witnessing 2000–2002 and 2008 is a little hard for many to handle. The Jeremy Siegel “Stocks for the Long Run” concept does not apply to many investors as they are not patient enough to hold out for 30 years while the market is down 38% or more. Most retirees, or those approaching retirement, are open to a strategy that does not resemble a roller coaster. In turn, the marketplace has started to provide some viable and dynamic solutions via ‘40 Act funds, which we like very much. These solutions are in contrast to the lack of transparency, low liquidity, and high expenses in the hedge fund world. Our most important job is the management of risk, not management of returns, to paraphrase Ben Graham. In our opinion, the unregulated world of hedge funds does not fit that profile. Bregman: The biggest change I have seen is the incredible migration of alternative strategies into the open-end ’40 act mutual fund format. Kerns: What is the biggest challenge to investing in alternatives? Alford: Due diligence is crucial, but many advisors don’t have experience with alternatives. With traditional alternatives such as hedge funds, managers do not offer much transparency into portfolio positions or investment process, making these investments difficult to evaluate. With liquid alternatives, although transparency is high due to the ’40 Act fund structure, most products have short track records, making it difficult to judge how these managers will perform over a full market cycle. The dispersion in returns between the best and worst U.S. large-cap equity manager might only be a few percentage points in any given year; in hedge funds, it can be more than 15 percentage points per year. The stakes are high for picking the wrong managers. Raby: Educating clients on the nuances of alternative funds. Bregman: The biggest challenge is fully understanding the risk-and-return opportunities of particular strategies in particular market environments. MorningstarAdvisor.com 41 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2013

Morningstar Advisor - June/July 2013
Contents
Contributors
Letter From the Editor
Not Your Values
How Do You Use Alternatives for Clients?
Working to Build a Niche
How to Put Buffett’s Investing Philosophy into Practice
Sophisticated Strategies for the Masses
Investments á la Carte
Investment Briefs
The Percentile Trap
Defense Firms Will Stay Aloft
Beware the Lure of Diversification
Using Alternatives in Practice
Managed Futures and Cash Rates
The World Is Getting Grayer
Waiting to Pull Up Anchor
The Price of Managing Volatility
Let’s Get Back to Basics
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Mutual Fund Urban Myths

Morningstar Advisor - June/July 2013