Stern Advice-Investors pressed to go alternative

WASHINGTON (Reuters) - If you work with an investment adviser, there's a decent chance that sometime during the last year, you've had a conversation about alternative investments.

There's also a decent chance you emerged from that conversation without understanding exactly what your adviser was talking about. Don't feel bad - there's a lot of jargon surrounding what Robert Maloney, a Holderness, New Hampshire, financial adviser, calls "the flavor of the day."

Strictly speaking, an alternative investment can mean anything that isn't a plain vanilla stock or bond, but now it represents a trendy grab-bag category that can include everything from gold or currency to mutual funds that employ hedges, leverage, options, short-selling, derivatives and more.

This entire category is being heavily promoted to financial advisers, who are in turn pitching it to their clients, as a way of limiting portfolio risk -- and justifying the adviser's fees.

"Alternative investing today is a dominant theme at all the conferences I go to," said David Wright, a managing director at Sierra Investment Management, in Santa Monica, a firm that advocates and employs alternative strategies. "A whole lot of it is market hype."

Money has been flowing into these funds, even as it flows out of traditional stock funds. In 2008, alternative funds held $78 billion in assets; that number almost tripled in three years to $218,700 in 2011, according to Cerulli Associates, a research firm that sees the market continuing to expand.

A majority of advisers -- 66 percent of a mix of commissioned brokers and fee-only advisers -- are inclined to employ alternative investment strategies, even for middle market clients, according to a study released earlier this month by Natixis Global Asset Management.

The most widely held alt category - absolute return funds, which aim to provide low but steady returns year in and year out - has grown hugely popular in the last two years, says Tom Roseen of Lipper, a Thomson Reuters company. The first absolute return fund was launched in 2000, he says. Now there are 117 different absolute return portfolios holding more than $69-billion in assets. (There may be more funds than portfolios, because different share classes of the same fund count as one portfolio, in Lipper parlance.)

So, they are getting lots of money and lots of attention. The question is, should they get yours? Here are some points to ponder when your adviser tries to have "the conversation."

-- Not all alts are the same. Some, like those absolute return funds, aim low and steady. Others use leverage to actually increase risk and potential return. The latter may include funds that triple the return of the Standard & Poor's 500 stock index, for example. You wouldn't want to buy a fund like that if you were looking to de-risk your portfolio.

In the month which ended May 17, for example, traditional large capitalization stock funds lost 5.58 percent, absolute return funds (one kind of alternative) lost 0.93 percent, and equity leveraged funds (another kind of alternative) lost 12.04 percent, reports Lipper.

-- Beware the "this time it's different" argument. There's a lot of talk about the "new normal" swirling around alternative investments. Wright, for example, makes the argument that traditional buy-and-hold investing in stocks and bonds is a discredited strategy and it's a "big myth" that you need stocks for the long haul.

But investors who buy into the idea that market fundamentals are changing tend to get burned when those markets regress to their mean. It's probably not a coincidence that the Natixis survey found that veteran advisers with more than 15 years in the business were far less likely - 59 percent to 76 percent - to recommend alternative strategies to their clients.

-- Define your terms. If you don't understand a product, don't buy it. If your adviser can't explain what's inside of the fund so you can understand it, it doesn't mean he's a super sophisticated adviser and you should pay him extra. It means (1) he doesn't understand it either; or (2) he'd prefer that you not understand it; or (3) he's not so good with descriptions. None of those is a good reason to give someone your money.

-- Follow the money. In many cases, these funds are being sold because they are really expensive compared with plain vanilla mutual funds and exchange traded funds (ETFs). The average equity market neutral fund (another category of alternative that aims to provide steady returns by using hedging strategies like buying some stocks while shorting others) charges 2.89 percent of assets in expenses every year, according to Lipper data, and they have a 3-year annualized return of 2.08 percent.

Another low-risk choice (albeit one that might not correlate with market neutral funds under every scenario) is the Vanguard Short-Term bond Index Fund, which has a three-year annual average of 3.4 percent a year, and charges 0.22 percent in expenses.

"Fees are even more important in these categories," says Josh Charney, a Morningstar analyst. "Some of these funds have low-risk, low-return profiles you would see in a bond fund, but they charge an egregious amount for that risk profile. We want to see funds with a low-risk profile be cheap."

-- Put them in their place. It may not hurt to have some kind of alternatives, such as commodities, in your portfolio for ballast, says Charney. Keep the allocation below 15 or 20 percent, and make sure you alter the rest of your portfolio to adjust for that. For example, if you load up on calm, steady alternatives that correlate to bond funds, you might hold fewer assets in bond funds.

-- Recognize that you might miss out. If you buy a triple-leveraged stock fund and the market tanks, you'll lose money twice as fast. But if you put a lot of money into a calm, hedgey risk-averse alternative fund and stocks take off like gangbusters, realize that you'll be left behind. "I don't know if people realize that when the go-gos are going, they aren't going to participate." That might be something else to ask your adviser about, when you have the conversation.

(The Stern Advice column appears weekly, and at additional times as warranted. Linda Stern can be reached at linda.stern@thomsonreuters.com; She tweets at www.twitter.com/lindastern .; Read more of her work at blogs.reuters.com/linda-stern; Editing by Gunna Dickson)