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 CNBC analysis.
- • Liquid alternatives (mutual funds employing hedge fund-like strategies) demonstrated resilience during market stress: market neutral funds declined 0.41% on average during Q4 2018 when the S&P 500 fell 13.52%, illustrating their portfolio stabilization role.
- • Expense ratios for liquid alternative funds typically exceed 1% and can reach 2% or higher, a material cost that advisors must weigh against diversification benefits when evaluating suitability for clients.
- • Advisors recommend an average allocation of 12–14% to liquid alternatives versus 4–8% for illiquid alternatives, with portfolio size and client time horizon serving as critical variables in determining appropriate exposure levels.
- • Retail investors face significant barriers to direct alternative investing; Morningstar's Jason Kephart advises against individual participation, emphasizing that professional advisor guidance and substantial minimum capital requirements make alternatives unsuitable for do-it-yourself approaches.
Summary
Traditional portfolio construction relying exclusively on equities and fixed income proved inadequate during market dislocations, as evidenced by 2008 when target-date retirement funds holding high-yield bonds experienced massive losses despite bond allocations intended to reduce volatility. Liquid alternatives—mutual fund vehicles offering hedge fund-like strategies—have emerged as a solution to address the imperfect correlation between stocks and bonds, according to Shana Sissel, senior portfolio manager at CLS Investments in Omaha, Nebraska.
The case for liquid alternatives is supported by empirical performance data. During the volatile fourth quarter of 2018, when the S&P 500 index declined 13.52%, mutual funds employing market neutral strategies (simultaneously holding long and short stock positions) averaged losses of only 0.41%, demonstrating meaningful downside protection. Managed futures funds, which maintain long and short positions across different futures contracts, represent another category within liquid alternatives offering portfolio diversification benefits.
However, the diversification advantage carries a material cost structure. Expense ratios for these funds frequently exceed 1% and can surpass 2%, representing a significant drag on returns that advisors must justify when presenting alternatives to cost-conscious clients. Additionally, retail investors face practical barriers to direct participation. Jason Kephart, associate director of multi-asset and alternatives strategies at Morningstar, stated unequivocally: "For retail investors, it's easy: Just don't do it," underscoring that professional guidance and substantial capital thresholds make direct alternative investment inappropriate for individual investors.
Industry consensus points toward meaningful allocation levels. Advisors recommend deploying 10% to 20% of client portfolios to alternatives to achieve measurable diversification effects, with 12–14% representing the average recommendation for liquid alternatives compared with 4–8% for illiquid alternatives. Successful implementation requires advisors to conduct rigorous analysis of client objectives, time horizon, and risk tolerance—fundamental fiduciary considerations that precede any allocation decision.
The case for liquid alternatives is supported by empirical performance data. During the volatile fourth quarter of 2018, when the S&P 500 index declined 13.52%, mutual funds employing market neutral strategies (simultaneously holding long and short stock positions) averaged losses of only 0.41%, demonstrating meaningful downside protection. Managed futures funds, which maintain long and short positions across different futures contracts, represent another category within liquid alternatives offering portfolio diversification benefits.
However, the diversification advantage carries a material cost structure. Expense ratios for these funds frequently exceed 1% and can surpass 2%, representing a significant drag on returns that advisors must justify when presenting alternatives to cost-conscious clients. Additionally, retail investors face practical barriers to direct participation. Jason Kephart, associate director of multi-asset and alternatives strategies at Morningstar, stated unequivocally: "For retail investors, it's easy: Just don't do it," underscoring that professional guidance and substantial capital thresholds make direct alternative investment inappropriate for individual investors.
Industry consensus points toward meaningful allocation levels. Advisors recommend deploying 10% to 20% of client portfolios to alternatives to achieve measurable diversification effects, with 12–14% representing the average recommendation for liquid alternatives compared with 4–8% for illiquid alternatives. Successful implementation requires advisors to conduct rigorous analysis of client objectives, time horizon, and risk tolerance—fundamental fiduciary considerations that precede any allocation decision.
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