Morningstar Advisor - April/May 2012 - (Page 38)

Spotlight How Much Is Enough? By Michael Coop Time to ditch the old 10% allocation rule. The rapid growth of liquid alternative mutual funds and exchange-traded funds, both in number and asset size, has challenged all definitions of alternatives, the perception of who should invest in them, and most important, how much should be invested in them. Investors Are Spoiled for Choice markets equities and bonds, listed private equity, infrastructure securities, equity volatility, and active strategies used by hedge funds. What Is Alternative? In a recent Morningstar and Barron’s survey, advisors and institutional investors cited “diversification with a low correlating asset” as the single most important reason for allocating to alternative investments.1 If equities are the mainstay of a client’s portfolio, then any alternative investments in the portfolio should provide decent returns and behave differently from the stocks, especially in equity bear markets. The worst returns from equities have occurred in periods when corporate profits fall, typically during recessions. This makes sense as corporate profits are linked to the economic cycle; recessions mean lower revenues, lower profit margins, and a fall in corporate profits growth. Poor returns from equities can also occur when equities become heavily overvalued. There are two tests investors can apply to tell whether an investment will behave differently from equities and, therefore, should be considered as an alternative. The first is whether the underlying income an investor receives from owning the investment (for example, commercial property rents, emerging-markets company dividends, interest payments by companies in the case of corporate debt) is as sensitive to economic growth as are corporate profits. Will the underlying cash flows of these assets fall when These new alternative-investing products have grown rapidly, in response to investor demand for diversification and liquidity. Over the past five years, the mutual fund industry has launched new products at a blistering pace of approximately four per month (Exhibit 1). At the end of 2011, Morningstar counted total alternative mutual funds assets of $122 billion after five consecutive years of inflows. Meanwhile, U.S.-equity mutual funds had five consecutive years of outflows, leaving those funds with just more than $260 billion in assets (Exhibit 2). This massive growth is also a global trend. The European version of mutual funds (UCITS) also offers exposure to a wide range of alternative investments and exchangetraded products. Advisors and retail investors can now choose from a bewildering array of investments touted as alternative, many available only to institutional investors in the past. These include mutual funds and exchange-traded products invested in commodities, Treasury Inflation-Protected Securities, REITS, emerging- As access to alternative strategies has expanded, so, too, has the very definition of alternative investing. Historically, alternatives were considered to be hedge funds— unregistered legal structures with liquidity restrictions and high-net-worth thresholds that prevented access to most retail investors. As a result, alternatives were considered investments suitable for a small portion of the population and the portfolio. Now, with more than 300 hedge-fund-like mutual funds (and several ETFs) available to the general market, the legal structure of an investment is no longer a defining characteristic. Even when trying to classify alternatives by their underlying assets or trading strategies, the challenge lies in the changing definition of alternatives over time. Ten years ago, emerging-markets equities and global REITs were largely grouped as alternatives. Does that classification hold today as these asset classes have been adopted by mainstream investors? And will commodities be considered alternative 10 years from now? To answer these questions, investors need to reconsider why they are allocating to alternatives in the first place; the answer is diversification. 38 Morningstar Advisor April/May 2012

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2012

Morningstar Advisor - April/May 2012
Letter From the Editor
We’re Too Smart
How Do You Use Alternatives?
Taking the Lead
How to Find Economic Moats
The Beauty of Currencies
No Clarity on Bonds
Four Picks for the Present
Investment Briefs
Performance Chasing, Evaluated
Technology’s Slim Pickings
How Much Is Enough?
The Fear Bubble
Three Traits of a Successful Long-Short Equity Manager
Why Absolute-Return Funds Fail to Deliver
An Economist’s Response to Crises
Undiscovered in Plain Sight
Untangling ETF Tax- Efficiency Myths
Central Banks Driving the Gold Rush
U.S. Industrials Could Add Some Magic to Europe-Weary Portfolios
No-Hesitation Allocation Funds
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Greatest Story Ever Told

Morningstar Advisor - April/May 2012