If a device existed that could monitor investors' stress levels, alarm bells would have been sounding and red lights flashing for most of the last year. The economy remains sluggish and its signals confusing, curbing the appetite for stocks. Meanwhile, the tradeoff between the tiny stream of income that bonds can generate and the rising level of risk don't compute.

Little wonder, then, that product providers are pitching their investment vehicles as "alternatives," and advisors are filling the holes in client portfolios with the growing panoply of such investments. Alternative investments that can help diversify a client's portfolio and boost absolute returns certainly already exist. After all, the price of gold, one of the most venerable alternative investments, has doubled in the last three years, and hedge funds, a newer arrival, are posting returns that outperform standard stock market indexes.



But there's good news and bad news when it comes to finding the right alternative investment idea and the right way to execute it. "It's much easier today to participate in segments of the market that used to be illiquid," says Theodore Enders, a portfolio strategist with Goldman Sachs Asset Management. To get exposure to commodity markets, "you used to have to trade futures, buy an oil tanker or dig a gold mine." Now there's an array of exchange-traded funds and managed-futures funds offering new ways to gain exposure to commodities.

But this new accessibility-and the decline in costs and rise in transparency that have accompanied it-comes with a hidden price tag. Advisors will need to devote more time to scrutinizing the ever-growing number of new products. And with each debut, they'll have to go back to the drawing board and decide whether the product makes the grade. The homework starts with the most basic questions: What does an "alternative" mean, and how can products with that label fit into clients' portfolios?

"One problem is that alternatives can mean so many different things," says Todd Millay, founder of Choate Investment Advisors in Boston. For Millay-a big believer in using alternatives to provide "meaningful" diversification-the trick is not to classify something as an alternative to plain-vanilla stocks and bonds based on name alone.

Some hedge funds don't offer a significant degree of diversification, he points out, so they won't work as alternatives. Meanwhile, some parts of the stock market-such as the frontier markets segment of emerging markets-don't behave like any other asset class, so they belong squarely in the domain of alternatives. "A real alternative has more to do with how the asset behaves than what it's called," Millay says.

Indeed, as the range of alternative investment products and strategies has multiplied, the difficulty in nailing down just what is meant by the word has grown exponentially. No two investors or advisors are likely to have the same definition.

To some advisors, an alternative might be anything beyond U.S. stocks and domestic fixed-income investments, ranging from commodities to hedge funds. To others, hedge funds and private equity funds are too much like regular stock investments to be considered true alternatives; these people favor, instead, such off-the-beaten-track products as oil well drilling partnerships and timberland. For one camp, the test of an "alternative" is the lack of correlation to mainstream assets; for another, it is the amount of alpha-or return that can't be explained solely by a market's movement-that can be generated in a less efficient or less liquid market.

All can find ways to justify their own opinions. "What we consider alternatives are those products that once used to be available only to ultra-high-net-worth investors or institutions and have become more available for mainstream individual investors," argues Brian Peardon, a wealth advisor at the Harrison Financial Group in Citrus Heights, Calif. "Some things that others call alternatives are really just using a traditional investment product in an alternative way, while others are real alternatives-direct investments in different kinds of assets", such as the energy royalty pools in which he invests his clients' assets.

For other advisors, the answer to "what is alternative" is related to what is possible. Tyler Vernon, chief investment officer at Biltmore Capital Advisors in Princeton, N.J., has seen the options become a lot more numerous in recent years as more hedge fund "feeder funds" have opened up, requiring only $10,000 or so in initial investments compared with previous minimums of $500,000 to $1 million. "Most of the clients we work with couldn't have afforded to set aside that much in a single fund," explains Vernon, who advises clients with $4 million to $7 million in assets and oversees some $650 million.

Vernon is always on the lookout for ways to help his clients access these funds, as he believes the compensation structure will lure most of the top talent into this arena. "You just have to look for the ways to access the products and you can get into funds that might not be household names, but that nevertheless have very good track records."

A case in point: Kettle Hill, a long/short hedge fund based in New York that Vernon says lost only 10% of its value in the bloodbath of 2008, rose about 45% last year and as of late October was up 8%. "And it offers monthly liquidity," he adds, meaning that investors who get nervous or need cash can withdraw funds on a month's notice.



One of the main advantages for alternative investment strategies, according to Vernon, is that they let investors take advantage of whatever short- to medium-term investment trends dominate. "We're looking for a way to capture whatever profits are out there, wherever they lie, without restrictions," he explains. "We want to find nimble investors who can go wherever those opportunities exist. That's why we're looking for more alternatives managers and fewer pigeonhole managers, who are confined to just buying something in a particular subcategory and hoping it goes up."

This kind of strategy requires a lot more research, he acknowledges, as well as developing relationships with small broker-dealers in order to keep the number of middlemen-and fees-to a minimum. Case in point: Vernon spotted a new investment vehicle being created by the DeBartolo family of real estate fame (its patriarch has been credited with inventing the shopping mall).

"They are raising money to buy properties in southwest Florida. And because they go in there quickly with cash, they can find interesting and undervalued properties," Vernon says. "It's a great opportunity for clients interested in a deep-value investment, and one whose returns aren't going to be tied to anything else in their portfolios."

For many professional investors, the hallmark of an appealing alternative asset class or investment strategy is an inefficient market. In frontier markets-think Vietnam or Nigeria-risk is perceived as so great that many investors shun it altogether. Those who have some edge-better access to information or a greater ability to winnow out useful information from "noise"-have a greater chance of pocketing outsize returns from their investment than those who frequent better-trodden parts of the global financial markets.

The trick is to know when an inefficient market becomes subject to mania, as happened in the leveraged loan market in the latter half of the last decade. "For several years, [that market] was poorly understood and yet had good underwriting standards," says Bob Browne, chief investment officer at Northern Trust. "At first people probably overestimated the amount of risk. Then a lot of money flooded into the asset class, and it became one in which everyone invested and in which the risk was suddenly underpriced."

Failing to recognize potential problems in an alternative investment category means risking the loss of clients' money. And the easier investment in any given asset class becomes, the higher the odds that something will happen to make profits harder to come by.



As the broad universe of alternative asset classes becomes better known and more diverse, investors are finding new ways to break it down. At Goldman Sachs Asset Management, for instance, Enders describes the firm's approach to asset allocation without really using the term "alternative."

At the heart of every client's portfolio is its core, a category that includes familiar stocks and bonds. Beyond that come satellite investments, a definition that encompasses what some other investors dub alternatives and others refer to resolutely as mainstream investments: emerging-markets bonds, real estate, commodities and high-yield bonds.

True alternatives, Enders explains, are something different from both core and satellite. "Our definition of alternatives is something that not everyone can buy: a hedge fund or private equity," he says. The real differentiating factor is not what the fund owns, but how it invests and manages its positions.

Despite the many definitions of an alternative investment-and a similar difference of opinion as to the most appealing alternatives on the menu, whether gold, discount-priced distressed real estate assets or hedge funds-there is one point on which everyone agrees. The average allocation to alternative investments, however defined, is on the rise. That's because investors simply cannot afford to be without them in the current market environment.



It's true the events of the fourth quarter of 2008 gave diversification a bad name, says Bob Browne, chief investment officer of Northern Trust in Chicago. Back then, the benefits of correlation evaporated, seemingly overnight.

But during the recovery, the need for diversification has become apparent once again as some asset classes have rebounded at different paces or demonstrated less volatility. "You can't put all your eggs in one basket if you want to create wealth," Browne cautions, and he's putting that advice to work for Northern Trust's clients. Three years ago, the average client had no exposure to gold; today, the typical investor has about 6% of the portfolio allocated to the precious metal.

Mike Savage, founder of Savage Financial Group of East Stroudsburg, Pa., is also a big fan of gold-and anything else he believes will help his clients steer clear of fiscal problems that he predicts will dog the U.S. dollar. So he suggests that his clients keep 20% of their assets in gold-related investments and also opts for another alternative source of returns: certificates of deposit denominated in foreign currencies in countries such as Brazil, Canada and Norway.

Most of his clients, who have about $1 million in assets on average, can't afford to be in more costly and less liquid alternatives such as hedge funds, he explains. But neither can they afford to be without alternative investments. "Even in their retirement plans, my clients are a lot more interested in finding alternatives than they were before 2008," he says.

As the global markets broaden and deepen, the benefits of diversification are likely to emerge as the chief argument in favor of alternative assets. Enders says that even the best managers are finding it hard to generate alpha.

Yes, it's still possible to find alpha in private equity funds. "That's a part of the market where managers can generate alpha simply by rolling up their sleeves and fixing things in their portfolio companies" and then capturing the increase in value when they resell those businesses. But in many cases, Enders adds, investors will benefit from what he dubs "balpha"-diversification within a portfolio to asset classes of all kinds.

In the 21st century, investors can take advantage of "balpha," even if they aren't on the Forbes list of the country's wealthiest citizens. "These days, 'alternative' doesn't mean funky or weird in the eyes of the average investor," Peardon says. So it's up to advisors to think through what the term does mean in the context of the portfolio strategies they are pursuing for their clients-and seek out the best of these ever-multiplying products to reflect that definition.


Suzanne McGee is a New York-based freelance writer and the author of Chasing Goldman Sachs.