There’s a lot of investor and advisor interest in alternative investments as a means to hedge against market volatility and to diversify a portfolio (all while boosting returns). Steve Hammers, chief investment officer and portfolio manager of the Compass EMP Alternative Strategies Fund, spoke to Financial Planning about how to design and evaluate an alternatives strategy:

Q: What alternatives are advisors looking for? Which ones are they possibly overlooking?

A: Advisors are looking for true alternatives; alternative mutual funds that can really force low correlations. Many advisors back in 2008, for example, had REIT funds, commodity funds, maybe they even had a stock long-short mutual fund they thought could help them in terms of a market downturn but then they realized that commodity funds fell just as much or more than their stocks.  Real estate funds fell more than stocks did and that stock long-short mutual fund that they thought had a hedge fell 25%. It concerned many advisors into thinking asset allocation didn’t work anymore. Thus, they’re looking for lower volatility but without sacrificing returns. That’s a big challenge — so what they need to be looking for is a mutual fund that can force low correlation, hedge downside risk, and when markets fall they can actually short those markets and cause that portfolio to go up when markets go down.

In terms of what alternatives advisors might be overlooking, I’d say they’re overlooking the commodity long-short asset class for one. They’re looking at commodities long-only and overlooking commodity long-short which can give you a hedge just like a stock long-short can. They’re also overlooking managed futures. Overall, they’re buying too many REITS or commodities long-only.

Q: What percentage of a portfolio should be in alternatives?

A: Let me start with what percentage. It has to be a percentage that has enough impact. If you found an alternative portfolio or fund at a low correlation to stocks and their beta is less than one what that means is the correlation is low and the volatility compared to the index is low. So if you have 10% in alternatives with a beta of zero because the correlation is low and you have 90% stocks, investors didn’t care that you go from -37% to -34% 2008 because that 10% could’ve been flat or positive and the 90% could’ve been down 40%. You have to allocate enough to have impact—10% doesn’t give impact. I recommend in the neighborhood of 30%-50% alternatives depending on the portfolio. A great portfolio of a modern investor rather than 60%stocks 40%bonds, if it were, for example, 33% stocks 33% bonds 33% alternatives, that’s a strong portfolio. Anything less just does not give enough impact.

Q: With the array of options in alternative funds, how do advisors evaluate and decide which alternative funds to invest in?

A: Evaluate historical performance of funds in the long-short asset classes to see how they did in down markets, such as 2008. There weren’t that many of these funds in 2002, but if there were find out how they did in the down market. That is the key because if you buy an alternative investment to help protect you on the down side and they’re going down just like stocks, they’re not going to help you. That’s the first thing. If you narrow that down even further to where you have the returns and the correlation you’re looking for, correlation is important. If you have 80% correlation to stocks, including a down year, that’s not going to help you. You’re looking for low correlation in down years and hopefully higher correlation in up years. Once you screen that down, and you know that this fund is designed to earn stock-type returns (10% at least), then you look at the fee. Look at funds that are average or below average in terms of cost.

Danielle Reed writes for Financial Planning.