Key Takeaways
- • Financial advisors should allocate 10% to 20% of client portfolios to alternative investments to achieve meaningful diversification benefits, according to industry experts cited in the analysis.
- • Liquid alternatives—mutual funds employing hedge fund-like strategies such as market neutral and managed futures—demonstrated significantly lower volatility during market stress; during Q4 2018 when the S&P 500 declined 13.52%, market neutral funds averaged only 0.41% losses.
- • Expense ratios for liquid alternative funds typically exceed 1% and can reach 2% or higher, representing a material cost that advisors must weigh against diversification benefits when evaluating suitability for clients.
- • Liquid alternatives serve as a critical tool to address a structural weakness in traditional portfolio construction: bonds and equities do not consistently move in opposite directions, as evidenced by significant losses in high-yield bond allocations during the 2008 financial crisis.
- • Retail investors should generally avoid direct participation in alternatives, according to Morningstar's Jason Kephart, who emphasized that alternatives require professional guidance and are "not a playground for do-it-yourselfers."
Summary
Traditional portfolio diversification through equities and fixed income has proven insufficient during periods of market stress, creating demand for alternative investment strategies among financial advisors and their clients. The primary limitation of conventional asset allocation became apparent during the 2008 financial crisis, when target-date retirement funds held risky high-yield bonds alongside equities, resulting in correlated losses across both asset classes. This breakdown in traditional diversification logic has prompted increased interest in liquid alternatives—mutual fund vehicles offering hedge fund-like strategies to retail investors without the typical constraints of direct hedge fund investment.
Liquid alternatives employ strategies including market neutral positioning, which simultaneously holds long and short stock positions, and managed futures, which establish long and short exposure across futures markets. Performance data underscores their diversification value: during the fourth quarter of 2018, a period of significant market volatility, the S&P 500 index fell 13.52%, while mutual funds utilizing market neutral strategies declined by only 0.41% on average, according to Morningstar data. This defensive characteristic addresses a core portfolio management objective—reducing concentration risk and volatility without sacrificing return potential.
However, the implementation of liquid alternatives carries meaningful costs. Expense ratios frequently exceed 1% annually, with some funds charging 2% or higher. According to Shana Sissel, senior portfolio manager at CLS Investments in Omaha, Nebraska, "the primary role of liquid alternatives in a portfolio is to provide an opportunity to diversify away from traditional equity and fixed income." To achieve measurable diversification benefits, advisors should consider allocating between 10% and 20% of client portfolios to alternatives, though allocation decisions must remain grounded in individual client circumstances, time horizons, and investment objectives.
Advisors considering alternatives must recognize that these strategies are not suitable for direct retail investor participation. Jason Kephart, associate director of the multi-asset and alternatives strategies team at Morningstar, cautioned that "for retail investors, it's easy: Just don't do it." This reflects the complexity inherent in evaluating and monitoring liquid alternatives, underscoring the professional expertise required to integrate these vehicles appropriately within diversified portfolios.
Liquid alternatives employ strategies including market neutral positioning, which simultaneously holds long and short stock positions, and managed futures, which establish long and short exposure across futures markets. Performance data underscores their diversification value: during the fourth quarter of 2018, a period of significant market volatility, the S&P 500 index fell 13.52%, while mutual funds utilizing market neutral strategies declined by only 0.41% on average, according to Morningstar data. This defensive characteristic addresses a core portfolio management objective—reducing concentration risk and volatility without sacrificing return potential.
However, the implementation of liquid alternatives carries meaningful costs. Expense ratios frequently exceed 1% annually, with some funds charging 2% or higher. According to Shana Sissel, senior portfolio manager at CLS Investments in Omaha, Nebraska, "the primary role of liquid alternatives in a portfolio is to provide an opportunity to diversify away from traditional equity and fixed income." To achieve measurable diversification benefits, advisors should consider allocating between 10% and 20% of client portfolios to alternatives, though allocation decisions must remain grounded in individual client circumstances, time horizons, and investment objectives.
Advisors considering alternatives must recognize that these strategies are not suitable for direct retail investor participation. Jason Kephart, associate director of the multi-asset and alternatives strategies team at Morningstar, cautioned that "for retail investors, it's easy: Just don't do it." This reflects the complexity inherent in evaluating and monitoring liquid alternatives, underscoring the professional expertise required to integrate these vehicles appropriately within diversified portfolios.
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