Take 20: Why Putting 20% in Alternatives Makes Absolute Sense

The Tradex Group Weekly Blog

April 24, 2013

By Richard Travia, Director of Research

Take 20:  Why Putting 20% in Alternatives Makes Absolute Sense

If there were three words post-2008 every investor should have written out on a post-it note, they were diversification, diversification and diversification. The lesson clearly learned is that spreading your eggs around is a lot more prudent than putting them in one or two baskets.

Yet more than four years following the global credit crisis and financial market rout, the predominant majority of individual investors still allocate their portfolios to traditional investments: stocks, bonds and other variations that incorporate no other strategies than buying equities and bonds in some form – typically in a 60/40 ratio or some variation of it.

The reason:  the vast majority of investors still aren’t even aware of, let alone educated on alternative investments such as hedge funds, private equity funds and managed futures funds that invest in less-traditional asset classes...Or if they are, they don’t have access to them.  Historically, the hedge fund asset class has been dominated by institutional investors. 

That's about to change, thanks to the Jumpstart Our Business Startups, or JOBS Act, which President Barack Obama signed into law in April 2012.  Once the U.S. Securities and Exchange Commission finishes re-writing the rules on advertising and soliciting, the Act will, for the first time, allow hedge funds and other alternative investment managers to advertise who they are, what they do and why they can be a healthy part of an investor's portfolio.

For years, hedge funds were strictly prohibited from marketing their products and soliciting new business. The at-best fuzzy rules dictated that only an individual who had passed the test of qualifying as an accredited investor – one with a minimum net worth of $1 million, not including the value of their primary residence – could speak to an alternative investment manager about their private offerings.  Even then the manager or anyone involved with the operation could not be viewed as soliciting the investor. 

Although the qualification rules still remain, The JOBS Act is a game changer.  While the much broader piece of legislation is aimed at giving breaks to small businesses, part of the Act makes for new allowances that permit hedge funds to market themselves – and their past returns – to a wider audience.  Just as Fidelity can advertise in a newspaper or on a highway billboard, so too will hedge funds be able to do the same.

 What this holds for accredited investors is the promise of additional transparency and a clear choice in true portfolio diversification, a must-have in the post-2008 world.  What it means for advisors and others who help steer money for clients is a duty to ensure that their clients are aware of – and diversified in – alternative investments – with at least 20% of a portfolio asset allocation.  Dean Catino of The Smarter Investor wrote in December 2012 that “By combining traditional asset classes with alternative investment options, like managed futures, commodities and others, as well as strategies centered on risk management and tactical management, there is a potential to increase returns and lower volatility.  It’s the sort of thing that university endowments do now, with some success.  As reported by the NACUBO-Commonfund Study of Endowment Results, over the last decade, the Standard & Poor’s 500 index returned a modest 2.7 percent, while 472 university endowments of all sizes consistently outperformed the index.  Interestingly, endowments with the greatest exposure to alternative assets performed the best, with average annual yields of 6.9 percent.”

As most investors now know, diversification is key to ensuring a healthy portfolio that can withstand shocks and volatility.  The key will be figuring out how best to diversify to ensure when the next negative surprise hits that the broader portfolio is protected.