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Posted by on May 15, 2014 in ETF Strategist

Alts Probably, Moderation Definitely!

Alts Probably, Moderation Definitely!

By Roger Nusbaum AdvisorShares ETF Strategist

The Wall Street Journal ran an odd point counter point on whether investors should use alternative investments in their portfolios. The ‘pro’ argument gave the argument you would expect about reducing volatility and also looked at the democratization of the space through ETFs and mutual fund. The ‘con’ argument basically said that alts weren’t all that but then focused on the logistical obstacles for funds not target by mutual fund companies; lack of liquidity and lack of transparency.

It was as if they were having two different conversations.

That out of the way, to the meat of the conversation;

I have long been a believer in using alts in moderation as a way to manage a portfolio’s volatility. The advisor making the ‘pro’ argument said something about 20% in alts which is way more than I would go…probably. The context of his 20% seemed to be as a static allocation. In a year like 2013 you arguably don’t need any alts exposure whereas in a year like 2008 you might want more than 20%.

The advisor making the ‘con’ argument didn’t mention one very important negative which is that despite the hopes of lower correlation to equities and zigging when stocks zag, 2008 showed that these strategies don’t always work the way they were supposed to. Some alt strategies did just fine but some did not “work.”

A big reason that many failed to deliver had to do with a shutting down of the bond market (more precisely there was a lack of normal market function) which was not reasonably predictable and did cause problems. To the extent that the crisis of 2008 was not a repeat of the crisis from 2000 then the next crisis will be its own event not a repeat of 2008 and unlikely to cause the bond market to cease functioning normally for a time.

While I believe the above is 100% true (I am referring to the part about the bond market being unlikely to cease up) that does not mean that a given alternative strategy won’t again disappoint for some unforeseen reason.

This makes the argument for not putting the entire alts allocation into just one fund (or strategy). Long/short, merger arb, hedge fund replicator, inverse/short fund, gold funds, a fund that does something with options, multi strategy (this is one we will see more of in the coming weeks from various fund providers) and all the others are all valid strategies but there is no guarantee they will all work when investors again most need them too.

However not all of them failed in 2008 and they will not all fail in the next crisis (or just plain old bear market), I would submit most will deliver as hoped for. Dividing a small allocation to alts among several generally unrelated strategies will obviously insulate against a failure to execute in one part of the alts universe.

To the static allocation to alts; as I mentioned above there are some years where increased alt exposure will make more sense than other years which would argue for dynamically allocating to alts in the context of executing a defensive strategy. For many years I have talked about a breach of the 200 daily move average (DMA) as a trigger for defensive action. Defensive action has included selling some holdings and buying things like alts.

And while I still would probably not go 20%, I would go from small to less-small as part of getting more defensive as I wrote about during the bear market.

A few months ago I had a fun Twitter debate over this with Josh Brown who basically said that if the world goes to hell, a 3% allocation to gold won’t help enough to matter and he was right but that has never been the context here.

There is value in using these exposures in a non-static way as I described above, you can go back to the randomroger archive from 2008 to see how this played out. If you agree, then it would be worth your time to learn about the various parts of the alts space (here I mean the ones easily accessible in some sort of fund) and of course there will be plenty of folks who will not agree.