Alternative investments were not spared last year’s market tailspin, but there’s been a notable comeback in returns on some alternative categories this year. Meanwhile, advisors and investors are more convinced than ever that alternatives are a key component of a well diversified portfolio.

Take Morningstar’s 1000 Hedge Fund Index, which lost 22.4 percent last year, but gained 17.1 percent through October of 2009. Hedge funds suffered last year because so many were forced to sell assets at fire sale prices (on top of being highly leveraged in illiquid investments) and were inundated with redemption requests, says Morningstar’s alternative investment strategist, Nadia Papagiannis. But surviving hedge funds and new hedge funds received much of the capital fleeing failing funds. Meanwhile, investor appetites for riskier assets began to return in June, says Papagiannis, after several months of positive stock market returns and improved liquidity. Risk appetites have improved further in recent weeks.

In fact, the majority of institutions and advisors believe the importance of alternative strategies has increased relative to traditional investments, according to a recent survey by Morningstar. More than 60 percent of respondents indicated alternatives will be as important or more important than traditional investments over the next five years.

The Morninstar survey found that many financial advisors use the term “alternative” to refer not only to hedge funds and funds of hedge funds, but to any strategy with a low correlation to capital markets.

In last year’s downturn, assets that are typically uncorrelated suddenly moved in tandem, and this has resulted in a greater interest on the part of advisors in finding additional diversification strategies, says Chris Butler, who heads Raymond James Financial Wealth Solutions Alternative Investment group.
Butler says the majority of advisors looking to use Raymond James’ alternative platform are more interested in the potential risk-management benefits of alternatives than in the potential to pad returns. Long/short equity funds may be able to provide greater protection in a down market environment, for example, says Butler, but clients need to understand how a short works and that there may be some leverage involved, and less liquidity.

“When you consider alternative investments, you distinctly need to think about what the investment is providing and the risks that come along with the strategy, in addition to the structural and operational risks,” says Butler. “A lot of the perception that alternative investments are high risk comes from some of the structural and operational concerns that are a part of evaluating an investment, whereas in many cases the strategies are designed to better manage risk for a client in a portfolio.”

Brian Schmucker, CEO of RiverNorth Capital, an investment advisor for individuals and advisors based in Chicago, says the advisors he speaks with are looking toward alternatives more and more over the last twelve months. “The traditional shops were all about Modern Portfolio Theory, which was pretty commonplace [for] years and [years],” Schmucker says. “And now with the market’s performance over last 18 months, people say, ‘Maybe we should manage our portfolios more like Harvard and Yale, with higher allocation to alternatives.’ We’re definitely moving in that direction.”

RiverNorth Capital runs an alternative strategy of its own, with a hedge fund as well as a retail closed-end mutual fund, RiverNorth Core Opportunity Fund (RNCOX).

There is certainly an increased awareness of the risks of alternatives and greater concern about the potential for fraud, says Raymond James' Butler.“Certainly post-Madoff, there is a general concern about fraud and, ‘Where is my money going?’” Butler says this concern is surfacing at both the advisor and the client levels. “Being able to articulate what your process is and the due diligence standards you follow have always been critical in our view, but it is more critical now because you have more people wanting to hear that information than they have in the past,” he says.

Many advisors and clients are paying closer attention to liquidity requirements, regulatory oversight, and transparency in the process of completing their due diligence, according to the Morningstar survey. In addition, some firms like Raymond James set parameters in terms of how much they allow advisors to allocate to alternative products and strategies to mitigate manager and strategy risk. “We generally like to use a rule of thumb that there should be no more than 5 to 10 percent [of a portfolio] in any particular investment, and probably for most individual investors 15 to 20 percent in alt investments,” says Butler.

While Butler’s group is dedicated to vetting products and managers, and educating advisors on the complex world of alternative investments, it also performs “a suitability review process of every ticket that comes through,” Butler says. “It provides an additional layer of evaluation, after which we might consult with the advisor, if we think a particular investment might be a little greater than we would like to see.”