In conversations with advisors, many are asking if they really need liquid alternatives to effectively manage retail portfolios. After all, many point out that liquid alts have underperformed stocks and bonds, the fees are high and clients don’t understand them. I believe they do need them and the case only gets stronger going forward. The reason is that traditional approaches to managing risk (i.e, diversification and asset allocation) seem to be gradually losing their ability to control volatility in the portfolio. While there are many contributing factors, the globalization of capital markets appears to play a leading role. Markets are more interconnected and trading also appears more synchronized than the past. Correlations between assets have also been trending higher for years and we seem to be experiencing steeper drawdowns. Yet retail allocations to liquid alternatives remain low, making up less than 3% of mutual fund industry AUM – a fraction of the allocations made by their institutional counterparts to ‘alternatives’.

Why the disparity?

In my opinion, the difference continues to be education. After all, the goals of a pension plan are actually very similar to the goals of a retail investor saving for retirement. Both need to make contributions, generate returns and manage risk. Similarities also exist between managing an endowment and managing a ‘decumulation’ portfolio for a retiree. But, educating retail investors on the trading strategies underlying many liquid alternative products is not easy while institutional investors have the benefit of a head start with hedge funds (as well as consultants helping them with the sourcing, sizing and selection decision).


“Mandates for alternative investments are expected to make up a significant portion of search activity, 32.5% on average, in 2016.”

“Consultants are primarily concerned about low expected returns, potential market volatility and clients’ ability to meet return hurdles in the current environment.”

Source: Evestment 2016 Asset Allocation & Consultant Survey, February 2016

Addressing a larger issue

A larger issue for many investors is the forward prospects for stocks and bonds. As many readers know, the traditional 60/40 mix of stocks and bonds has served as the ‘core’ of many institutional portfolios, delivering inflation-adjusted returns of 5% or more dating back to the 1980s. For Endowments and Pensions, ‘Cash + 5%’ has always been an important net hurdle rate to meet spending and actuarial return assumptions (many pensions set their actuarial return targets on a nominal basis when inflation was higher). But since 2000, the bedrock of many portfolios has become less reliable in terms of returns and less stable in terms of volatility (see table below).


Source: Data from Morningstar. 60/40 portfolio is invested January 1, 1980 and re-balanced annually. 3 mo. T-Bills are used as a proxy for inflation. Ref. code 16-05-12A

For example, during the decades of the 1980s and 1990s, a 60/40 portfolio consisting of the S&P 500 index and the Barclays Aggregate Bond Index consistently delivered a hurdle return of cash + 5% over rolling 3 year periods (column 4). But, beginning in 2000, the returns have fallen dramatically and the 60/40 portfolio produced negative returns in 30% of the rolling 3 year periods (column 3). Worse, during the financial crisis, this core portfolio of stocks and bonds jumped the guardrails, experiencing a swing in its rolling 3 year annualized volatility from roughly 4% before the crisis to 13% afterwards. The result was a drawdown of more than 30% despite the fixed-income component rising 6%.

Hindsight is always 20/20

In retrospect, retail investors didn’t really need risk-managed strategies over the past several years as both stocks and bonds delivered strong returns with low volatility. Predictably, many retail investors have been bulking up on stock index funds and shifting fixed-income portfolios towards credit-sensitive areas of the bond market. But times have changed and many are forecasting lower returns for both stocks and bonds ahead. Even the Fed has weighed in and warned investors to expect increased volatility in markets. Given we’re 7+ years into this bull market (one of the longest on record) and Central Banks continue to run zero rate policies, it would seem both logical and prudent to seek opportunities to de-risk portfolios, including adding liquid alternatives. This is especially relevant for retail investors entering the distribution phase where sequence of returns is now a more proximate risk (given both drawdowns and recovery times are magnified due to portfolio outflows). Retail investors could learn from Endowments and Pensions who have their focus squarely out the windshield on the road ahead.

Van Etten Consulting provides training and consulting services to Asset Managers and Broker/Dealers. The information contained herein represents the opinions of Van Etten Consulting and is intended for investment professionals only and should be viewed as educational content and not be construed as investment advice.

© Van Etten Consulting and, 2016. Unauthorized use and/or duplication of this material without express and written permission from this site’s author and/or owner is strictly prohibited. Excerpts and links may be used, provided that full and clear credit is given to Keith Van Etten and with appropriate and specific direction to the original content.

by | May 23, 2016 | Alternatives, Featured

The views expressed in this material are the views of the author through the date of publication and are subject to change without notice at any time based upon market and other factors. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. This information may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable. Past performance does not guarantee future results. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon and risk tolerance.