Adding Diversification with Liquid Alternatives



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Article Written By: Wealth Management Systems Inc.

Courtesy of: Bill Martin, CFP®, Financial Advisor 1845 Group at Morgan Stanley

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Adding Diversification with Liquid Alternatives



This article explains how a retail investor with a diversified stock and bond portfolio may be able to enhance asset allocation by adding alternative investments through conventional investment vehicles like mutual funds and exchange-traded funds.



For most investors, alternative investments bring to mind complex investment strategies available only to institutions and the ultra-wealthy through private, illiquid partnerships that charge high fees. However, with the recent growth of liquid alternatives, many of these strategies are now available through mutual funds and exchange traded funds (ETFs), and investor access to these once exclusive investment strategies is expanding.


Alternative investments comprise a multiplicity of asset classes and strategies. They are basically defined as any investment that falls outside the traditional asset classes of stocks, bonds and cash. The universe includes, but is not limited to: commodities, private real estate, managed futures, precious metals, private equity and numerous hedged strategies.


Liquid alternatives, unlike private offerings, do not require investor prequalification; have relatively low investment minimums; and provide portfolio improved transparency, daily liquidity and net asset value pricing. Performance of a liquid alternative fund, however, may vary from a private offering with a similar objective because of statutory limits on illiquidity, leverage, short sales and derivative securities.


The common thread uniting private and liquid alternatives is they both tend to generate returns that have low or negative correlation with traditional asset classes, and as a result, may be used as a tool to diversify portfolio risk and mitigate a significant decline in any one holding or investment type.1


Refining Asset Allocation

Equities have historically been the driver of long-term investment growth, but they are also the asset class with the greatest risk of loss. Suppose in 1990 you added a 20% allocation of diversified alternative asset classes and strategies to a conventional portfolio of 60% stocks, 35% bonds and 5% cash, resulting in a new portfolio of 45% stocks, 30% bonds, 5% cash and the balance in alternatives.2


By the end of 2014, the portfolio with alternatives would have earned a 7.7% average annual return, compared with 6.9% for the traditional portfolio; annual volatility for the portfolio with alternatives was 8.2% versus 9.5% for the traditional portfolio. The alternatives’ uncorrelated returns serve as a buffer, muting the overall severity of drawdowns and creating outcomes that were still equity-like but with a bit lower volatility.4


As we enter a period in which interest rates are forecast to rise, and equity and bond price are expected to be volatile, liquid alternatives may likely play a similar role in portfolio diversification for smaller investors. Here’s why:


Diversifying an equity portfolio with an allocation to bonds and cash is the conventional risk management tool for most investors. However, the end of a 30-year bull market for bonds in 2013 – combined with an impending interest rate increase (interest rate normalization) – has raised questions about the viability of this long-held strategy.


In the view of Morgan Stanley Wealth Management’s Global Investment Committee, the process of interest rate normalization is likely to produce above-average volatility in both stocks and bonds. Against a backdrop of muted, subpar growth, investors will need to look at other methods in an effort to improve returns and reduce volatility. Liquid alternatives are a possible solution. I would like the opportunity to work with you to determine if your portfolio might benefit from an allocation to this emerging market segment.




1 Diversification does not guarantee a profit or protect against a loss in a declining financial market.


2 The 20% consists of an equal-weighted basket of Morgan Stanley Wealth Management’s Global Investment Committee alternative asset categories: commodities (ex-precious metals), represented by Dow Jones-UBS Commodities ex-Precious Metals Total Return Index; precious metals, represented by Dow Jones-UBS Precious Metals Total Return Index; hedged strategies, represented by HFRI Funds of Funds Composite Index; managed futures, represented by the Barclay BTOP 50 Index; private equity, represented by Thomson Reuters Private Equity Performance Index; private real estate, represented by NCREIF Index and publicly traded real estate, represented by FTSE EPRA NAREIT Global Total Return.


3 Source: Morgan Stanley Wealth Management Investment Products and Services


4 “An Outcomes-Oriented Approach to Alternatives,” by Lisa Shalett, Head of Investment and Portfolio Strategies, Morgan Stanley Wealth Management; standard deviation is a measure of the volatility of a security’s return. It is a statistical quantity measuring the magnitude of the daily price changes of a security.


The S&P 500® index is a common gauge of the US equities market. This capitalization weighted index includes a representative sample of 500 leading companies in leading industries of the US economy.


Barclays Capital US Aggregate Bond index represents securities that are SEC-registered, taxable and dollar-denominated. The index covers the US investment grade, fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.


Past performance does not guarantee future results.


Indexes are unmanaged, and one cannot invest directly in an index.


Alternative strategy mutual funds may employ various investment strategies and techniques for both hedging and more speculative purposes such as short-selling, leverage, derivatives and options, which can increase volatility and the risk of investment loss. Non-traditional investment options and strategies are often employed by a fund’s portfolio manager to further a fund’s investment objective and to help offset market risks.  However, these features may be complex, making it more difficult to understand the fund’s essential characteristics and risks, and how it will perform in different market environments and over various periods of time.  They may also expose the fund to increased volatility and unanticipated risks particularly when used in complex combinations and/or accompanied by the use of borrowing or “leverage.”  The fund’s prospectus will contain information and descriptions of any non-traditional and complex strategies utilized by the fund.   


Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond’s maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/ or interest payments from a given investment may be reinvested at a lower interest rate.


Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment. Companies paying dividends can reduce or stop them at any time.


Investors should carefully consider the investment objectives and risks as well as charges and expenses of a mutual fund/exchange traded fund before investing.  To obtain a prospectus, contact your Financial Advisor or visit the fund company’s website.  The prospectus contains this and other information about the mutual fund/exchange traded fund.  Read the prospectus carefully before investing.


If you’d like to learn more, please contact Bill Martin, CFP®.


Article by Wealth Management Systems Inc. and provided courtesy of Morgan Stanley Financial Advisor.


The author(s) are not employees of Morgan Stanley Smith Barney LLC (“Morgan Stanley”). The opinions expressed by the authors are solely their own and do not necessarily reflect those of Morgan Stanley. The information and data in the article or publication has been obtained from sources outside of Morgan Stanley and Morgan Stanley makes no representations or guarantees as to the accuracy or completeness of information or data from sources outside of Morgan Stanley. Neither the information provided nor any opinion expressed constitutes a solicitation by Morgan Stanley with respect to the purchase or sale of any security, investment, strategy or product that may be mentioned.


Morgan Stanley Financial Advisor(s) engaged RGVision Magazine to feature this article.

Bill Martin, CFP® may only transact business in states where he is registered or excluded or exempted from registration business, follow-up and individualized responses involving either effecting or attempting to effect transactions in securities, or the rendering of personalized investment advice for compensation, will not be made to persons in states where Bill Martin, CFP® is not registered or excluded or exempt from registration.


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