As investing in alternatives such as real estate, private equity funds, hedge fund strategies and commodities grow in popularity, the way these are being used by institutions and investment advisors is changing.
Institutions started broadly investing in alternative investments after the Internet bubble burst, said Darren Spencer, director of alternative investment consulting at Russell Investments.
"People were looking at different approaches to diversity the risk associated with long-only equity investing. There is significant risk associated with that, both in terms of the volatility of those returns but also the risk of experiencing significant draw downs, or the risk of the equity market falling by 30%," he said.
"That would require a pension fund to increase contributions to keep the funding ratios up, and non-profits would still have to build buildings and fund student aid. It's difficult to stomach that volatility in an environment when you're trying to achieve" objectives such as those, he said.
Institutions' view was that "we want to diversify our equity risk because we clearly have to be invested in assets that have a growth orientation but we want to do that in a way that we're not exposed to so much volatility."
Today, according to Russell's 2012 Survey on Alternative Investing, published earlier this summer, respondents hold an average of 22% in alternative investments, compared to 10% in 2010.
While the average is 22%, the range is from 10% on the low end to 50% to 60% on the high end, Spencer said. Non-profits, which typically have someone from a hedge fund or private equity fund on their board, and are the most familiar and comfortable with alternatives because they've been using them longer have the larger exposures, he said.
Now that institutions have a sizable amount of alternative assets, they are thinking about the category in the context of the total portfolio, Spencer said. "What is important for people to understand when we are talking about alternatives broadly is that clearly the term means a lot of different things," he said.
The category includes hedge funds, private equity and real assets. "Within these, you have a very heterogeneous mix of strategies in terms of risk return objective, liquidity, etc., so how alternatives fit in are driven very much by what is the investor trying to achieve," Spencer said.
For instance, if an institution wants to mitigate volatility, it might invest in global macro hedge funds and tactical trading strategies including managed futures funds, he said. "The correlations to equities are flat to negative," he said.
If institutions are looking to generate income, as many non-profits are, they'd likely look at core private real estate, which has shown over time to be a good source of income, Spencer said. If an institution is looking for alpha, it might look at long-only commodity managers, and if the target is long-term growth, an institution might look at private equity and venture capital. "The alternatives universe is a broad spectrum. How investors use them is going to be driven by their circumstances and investment objectives," Spencer said.
One trend that Russell is seeing more of is institutions using separate accounts for hedge fund investments. With a separate account, "you're able to structure investments to target specific exposures. So for example, I want more exposure to tactical trading managers. Or I want to be able to structure a portfolio that gives me an equity return but with two-thirds of the volatility of the equity market," Spencer said.
For their part, independent advisors are increasingly interested in alternatives as well. One category they like is managed futures, according to Nadia Papagiannis, director of alternative investments at Morningstar. This category includes price-trend-following strategies, such as funds betting in stock, bond, currency and commodity futures.
"It appears that in worst of times, managed futures tends to do the best," she said, adding that the category "can provide a buffer in downturns but make money over the long run."
The larger trend is the growth in multi-strategy alternative funds, which invest in multiple alternative strategies and are typically managed by multiple managers, according to Papagiannis. The strategies are a mix of Morningstar's other alternative categories, including long-short equity, market-neutral, bear market, currency, managed futures, nontraditional bond, and volatility.
Morningstar's multialternative category housed 83 one-stop-shop, multistrategy alternative mutual fund products as of July 31. Of the 83 funds, 21 launched in 2011. So far in 2012, 11 more have made their debut.
Financial advisors like these funds because they're are confused about how to allocate to alternatives, Papagiannis said. "With traditional strategies and funds you only have to pick the managers," she said. "With alternatives there is no standardized allocation."
Once an advisor decides on the allocation, he or she then has to determine what alternatives to use, which strategies within those alternatives and what manager to use. Most managers haven't been around as long as mutual fund managers, making it harder to assess them, Papagiannis said.
These multialternative funds often have a relatively high correlation to equities. Of the 36 funds that have been around at least a year (through July), 22 exhibited a 52-week correlation to the S&P 500 Index north of 70%, Papagiannis said.
The reason is that advisors and investors are looking for funds with some sort of growth potential, she said. So managers are "putting in strategies like long-short equities and non-traditional bonds that give it a high correlation but also some kind of return potential," she said.
While institutions are integrating alternative investments into their portfolios by, for example, making a long-short equities investment a subset of the overall equities portfolio, advisors are lumping all of the alternatives together, she added.
When asked why they are investing in alternatives, advisors said they were looking for diversification and low correlation to the movement of stocks and bonds, the Morningstar survey found.
Fees are advisors' biggest concerns, because they are used to mutual fund fees and not used to investing in hedge funds, she said. Lack of liquidity is a second concern, the survey found.