It’s been several years since the acute losses of the financial crisis yet many advisors tell me that their clients continue to exhibit symptoms of a post-traumatic financial stress disorder. Anxious about stock markets, many remained out of equities, a symptom which caused 54% of investors to miss recent broad market rallies, choosing to stay in cash and bonds according to a 2013 Gallup poll. The biggest challenge many advisors I speak with face is helping their clients wade back into the markets so they can achieve the growth they need to meet their long-term investment goals.

To make matters worse, many investors continue to believe in yesterday’s safe havens, and their portfolios are often overweight treasuries and burdened with large cash balances with little understanding of the embedded risks. We believe this myopic view of risk is likely to end in further disappointment. With lower interest rates and the prospects of longer retirements, many clients are falling further behind on achieving their financial goals. With rates low and the inflation eroding the purchasing power of cash holdings, the need for growth is as real as ever.

Coming to Grips with a New Reality

After reviewing their 2013 year end statements, many investors realized that there is no free lunch and there are no risk-free assets.  Even cash and bonds had negative real or absolute returns last year (which further compounded the investor dilemma).  According to BlackRock’s recent Investor Pulse research, which surveyed 17,000 advisors and clients around the globe, cash makes up nearly half (48%) of the value of investor portfolios in the US.  In dollar terms, the ICI reports that roughly $2.7 trillion remains in money market funds. The reality is that these strategies are unlikely to generate the returns needed to help investors reach their goals.

Many advisors I speak with are taking action and talking to their clients about the risks inherent in being underweight growth assets in this environment. The Investor Pulse supports what I am hearing from advisors when I am on the road—48% of advisors cite being too risk averse as a common client mistake, and 40% plan to allocate more to equities and multi-asset products this year to help clients reach their long-term goals.

In our view, equities still represent the best opportunity for growth.  So given this backdrop, how can we help investors gain the confidence they need to come back into this market?  Many RIAs I speak with are tackling this challenge by using diversifiers like liquid alternative strategies that focus on managing volatility while providing access to equity markets. Whether used as a way to dampen volatility or enhance returns, the alternative investments once available only to qualified institutional investors are finding their way into my Mom’s portfolio.

Not my Mother’s Oldsmobile

The universe of alternative investments has significantly expanded in recent years as more and more investment managers try to capitalize on the increasing interest in liquid alternatives. With over $130B flowing into the category over the last 3 years, many new funds have emerged that claim to offer reduced volatility and low correlation to equity markets. However not all alternatives are created equal.

Many alternative strategies fail to live up to expectations. In many cases, liquid alternative funds exhibit much higher correlations to equity markets than they claim, drastically reducing the potential diversification benefits. Still others add new, unwanted sources of risk by making large directional beta bets or assuming excessive exposure to a single security. Distinguishing between well-constructed alternative equity strategies and those likely to fall short is critical if the ultimate goal is growth with reduced risk.

Avoiding Lemons

Selecting a liquid alternative strategy is made all the more challenging by the fact that many strategies lack long-term track records. We suggest starting the strategy evaluation process with a few simple questions:

  1. Has the strategy demonstrated higher than expected volatility or correlations to equity markets compared to other alternative strategies?  For example, does it exhibit a correlation to equities over 0.6?
  2. Is the investment philosophy intuitive, and more importantly, does the investment process seem capable of exploiting market inefficiencies in a repeatable way, distinguishing skill from luck?
  3. Does the team itself have previous experience managing alternative strategies, and can a pre-existing strategy actually be replicated within the confines of a 40 Act fund?

Back to Growth Again

As you explore the potential for liquid alternatives to help risk-averse clients add growth potential back into their portfolios, we encourage you to visit BlackRock’s Alternative Investments Education Center for more information on liquid alternatives and how they can be incorporated into your clients’ portfolios.

Written by: Hollie Fagan Managing Director