Clients may soon be asking a lot of questions about alternative investments.
After an eight-year bull market, accompanied by volatility well below the historical average, we may be entering a sustained period of lower returns and heightened volatility. Many investors may then turn away from current favorites like passive index funds and ETFs, much as investors turned away from online, self-directed brokerage in response to the bursting of the tech bubble in the early 2000’s.
In such an environment, investors are likely to turn toward active management in general and alternatives in particular, as they search for returns and volatility mitigation.
It's important to remind clients that alternative products typically hold more nontraditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions.
But alternatives are also potentially positioned to perform well in such an environment, given their ability to generate returns in both rising and falling market environments, while at the same time investing across multiple asset classes such as stocks, bonds, currencies, and commodities.
After working closely with advisers for the better part of 25 years, I have found that successful advisers utilize a thorough, thoughtful and regimented approach toward alternatives. This approach entails:
· Know why you are using alternatives.
These advisers use alternatives because they believe the use of these instruments will help their clients achieve their investment objectives. Such advisers clearly define their clients’ investment objectives and will only allocate to alternatives after they are convinced that alternatives can help their clients achieve those objectives.
· Do your homework before investing.
While no one likes doing homework, good advisers spend time researching alternatives in order to determine whether or not they make sense in their client portfolios.
Through this research process, these advisers gain a realistic understanding of what they can expect from the different types of alternatives, especially with regard to performance. Given the unique nature of alternatives, it’s critical for advisers to understand what drives performance, and what to expect during different parts of the market cycle.
· Have a forward looking perspective and remain disciplined in your use of alternatives.
In my experience, successful advisers are forward looking and build a portfolio based on what they see on the horizon. Such advisers eschew a backward looking approach in which investment decisions are based on the previous investment environment.
Furthermore, these advisers are disciplined with regard to their investment approach. Once the decision is made to add alternatives, these advisers make them a core part of their investment process. As a result, these advisers avoid the biggest and most common mistake I see with regard to alternatives, namely, performance chasing.
· Communicate effectively with your clients about why alternatives are being used.
Advisers need to have effective conversations with their clients about why alternatives are being used within the portfolio.
The advisers must be able to link the use of the products to help the client achieve their investment objectives, while setting realistic expectations about what the client can anticipate from the alternatives being utilized.
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