Alternative Investments in Focus
American Century Investments
November 10, 2011
American Century Investments recently conducted a survey of financial professionals to better understand their view and use of alternative investments. This information can be useful for individual investors as well, particularly for those interested in information about types and vehicles for alternative investing currently favored by financial professionals.
“Alternative investments” are defined as those outside the traditional “big three” of cash, bonds, and stocks. These alternatives include commodities, real estate, and inflation-linked securities, among many others. Alternatives have surged in popularity in recent years, as investors and their advisors seek out new and potentially more effective ways to diversify and reduce risk in traditional balanced stock, bond, and cash portfolios.
Rationale for Alternative Investments
Broadly speaking, the rationale for incorporating uncorrelated assets—those that behave differently for a given economic or market event—is that they may reduce overall portfolio risk and improve risk-adjusted performance. This more balanced approach provides exposure to a number of different asset classes without leaving investors overexposed to any single area or segment of the market. Indeed, diversification works on the principle that by sacrificing some absolute return potential, you may reduce the risk you take by spreading your investment across asset classes. Of course, diversification cannot ensure a profit or protect against loss in a declining market, but it does provide a constructive investment framework that can reduce portfolio volatility and may improve an investor’s risk-adjusted performance over time.
It should be no surprise then to find that financial professionals appear to use alternatives to manage risk rather than seek to generate out-sized returns. A “low correlation with traditional asset classes” was identified as the “most attractive” feature of alternatives by 41% of financial professionals, followed by “potential for broader portfolio diversification,” which garnered the second-most responses at 29%. The “potential for higher returns” was cited by only 12% of respondents. Given the market gyrations of the past few years, financial advisors may believe that their clients are more risk averse than ever and are willing to give up performance on the upside in order to have some protection in a falling market environment.
Alternatives Use: High and Rising
With these potential benefits in mind, it is understandable that use of alternative investment strategies by financial professionals is widespread. In fact, 80% of study participants report they are currently using alternative investments with their clients, while an astounding 95% of financial advisors participating in the survey have some level of experience with these strategies. Not only is the use of alternatives high among financial advisors and their clients, but their popularity is also rising. Indeed, among those currently using alternative strategies, 55% plan to increase use in the next year.
However, while this suggests that so-called “alternatives” are becoming mainstream, they are not yet a part of every client’s portfolio. According to the financial professionals participating in the study, only about one-third of all their clients use alternatives.
How Much to Allocate to Alternatives
As the name suggests, alternatives are not meant to be core portfolio holdings, but smaller slices of a larger investment pie. It turns out that how much you should allocate to alternatives depends a great deal on your unique investment goals, time horizon, and risk tolerances, among other factors. On average, though, the survey indicates that a typical client’s asset allocation to alternative strategies stood at 17%; however, this allocation varies by the financial professional’s experience level with the investments.
This makes intuitive sense—the greater a financial advisor’s understanding and familiarity with alternatives, the more likely he or she will be to recommend inclusion in client portfolios. The survey indicates that financial professionals with “extensive” experience allocated an average of 23% of a client’s portfolio to alternative strategies. By comparison, those with “basic” experience allocated an average of 14% of a client’s portfolio to alternatives.
Alternative Investments Used Most Often
The range of alternative investments available today is truly staggering, running the gamut from fairly intuitive commodities such as gold and oil, to more complicated products such as “bear market” investments made up of derivatives or other instruments meant to move opposite the broader market. What the survey found, as depicted in the accompanying graphic, was that financial intermediaries gravitate toward more tangible (e.g., precious metals, natural resources) and less esoteric strategies. As a result, commodities were the alternatives used most by financial professionals, followed by real estate investment trusts, or REITs.
Perhaps this is because commodity and real estate-related investments may be easier for financial professionals to explain to clients. Indeed, “difficult to explain features, benefits, and risks to clients” was the most frequently cited challenge associated with the use of alternatives (named by 41% of respondents). Clearly, individual investors and financial professionals may benefit from tools/information to better explain alternative strategies.
How Advisors Get Their Alternative Asset Exposure
The study also indicates that mutual funds are the most popular way for financial intermediaries to provide alternative strategies to clients. Among professionals currently using alternatives in client portfolios, 42% cited mutual funds as the preferred mode of access, followed by exchange traded funds at 28%. Among those selecting mutual funds as a primary mode of access, respondents used words and phrases like “simple/ easy, offering diversification and/or having active and/or professional management” when describing the attractive qualities of the investment vehicle. Regardless of experience level or type of financial professional, mutual funds remained the preferred access mode.
Conclusion: Alts as a Small Part of a Balanced Portfolio
It is our belief that a balanced strategy incorporating exposure to the broad asset classes is the best way to maximize the probability of hitting one’s investment targets. Incorporating modest exposure to alternative investments with low or negative correlation to other major asset classes may improve risk-adjusted returns in such a framework. Of course, past performance cannot guarantee future results, but this broadly diversified approach is the best way we know to minimize risk and maximize return over time. This means alternative investments might be well suited to play a small role as a diversifier in a larger portfolio. Individual investors would do well to consult a financial professional about ways “alts” might make sense given their unique investment goals and circumstances.
The results of the October study were drawn from online surveys of 300 financial professionals, including financial planners, advisors, personal financial consultants, brokers, and registered investment advisors. Respondents averaged more than 15 years of business experience, and participation was contingent on having a book of business equal to or greater than $10 million.
American Century Investments® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: U.S Investment Professionals
Diversification does not assure a profit nor does it protect against loss of principal.
Investment return and principal value of alternative investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Statements regarding specific assets or holdings represent views of survey respondents and compensation has not been received in connection with such views.
This information is not intended to serve as investment advice; it is for educational purposes only.
Due to the limited focus of alternative investments, they may experience greater volatility than funds with a broader investment strategy. They are not intended to serve as complete investment programs by themselves.
The opinions expressed are those of the survey respondents, and are no guarantee of the future performance of any American Century Investments portfolio.
(c) American Century Investments
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