It’s an enticing idea: Combine alternative investments such as hedge funds, or even ETFs targeting hard-to-reach areas of the market, with traditional asset classes to increase diversification and lower portfolio volatility.

Easier said than done.

Alternative funds that harness the talents of superior managers may not be open to everyone. Options for those who don’t qualify may be limited to vehicles with performance that’s closer to the mean return of all managers.

Assessing alternative fund performance is another major challenge, because these vehicles self-report and there’s no investable index for benchmarking.

None of this means alternatives can’t add value. But finding that value can be difficult, even for advisors. Following best practices can help you avoid common pitfalls of alternative strategies.

Understand the model

Our U.S. research underscores the difficulty of forecasting returns, risks, correlations and cross-correlations for asset classes, sub-asset classes and investment strategies, especially in the short term.

When using a mean-variance optimization model, looking at different periods can lead to different results (see “History can be misleading,” this page). For each set of asset classes, we examined returns, volatility and correlations from 1988 up to the construction date of the portfolio, to determine the most efficient combination of asset and sub-asset classes. We then created optimized portfolios based on the best performance each asset class achieved in the given period, and attempted to replicate performance during a new time period.

We evaluated these portfolios over the next three-year period, considering how different lengths of time and actual periods affected results. We then compared returns of the optimized portfolios with a benchmark of 60% stocks and 40% bonds. When we tried to replicate the positive results of the original portfolios, in most cases the optimized portfolios did worse than the originals. We also found the volatility of the benchmark and model portfolios differed.

Real life is messy

No asset class provides high (or low) relative returns forever. Showing clients potential volatility can help you arrive at the allocation suited to each client’s comfort level.

Many alternative strategies may only be as successful as the manager running them. Other problems include low capacity, high costs, uncertain pricing, confined market opportunities and a lack of transparency.

Finally, seasoned advisors know that managers who succeed in one instance may fail in the next due to high costs, commoditization of their approaches, marketplace crowding or risk concentrations that are difficult to detect.

Qualitative factors, such as manager skill, availability and reliability of performance data, complicate the evaluation process for alternative strategies. As a result, an advisor may be wise to look to liquid markets with broad diversification and risk controls, avoiding strategies with excessive leverageor concentration.

Atul Tiwari is managing director of Vanguard Investments Canada.

Originally published in Advisor's Edge Report

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