The past five years have seen the CBOE Volatility Index (VIX), a measure of volatility in the S&P 500, spike to levels of 80.86 (November 20, 2008) and 48 (August 8, 2011) from levels of between 15 to 20 only a few years ago.
From 1990 – 2011, the HRFI Fund of Funds Index
had a net return of 7.85% with a standard deviation of 5.88. The S&P 500 index returned 8.61% over the same period but with a standard deviation of 15.06.
Many investors are making the switch from more traditional asset classes to alternatives. Is this a smart move or are investors taking more risk than they should?
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Particularly for income-seeking investors, the Fed interest rate target of between zero and .25% has made it difficult to live off of traditional income-producing instruments.
The Barclay’s Aggregate Bond index returned -.02 in February, -.55% in March, and only 1.11% in April. The S&P 500 produced total returns of 4.30% in February, 3.29% in March, and -.63% in April.
Since alternatives offer comparable returns over time with less volatility, who can blame investors for looking elsewhere?
Alternatives are showing up in retirement accounts, mutual funds, and even variable annuities. Demand has grown so much for the vehicles that the number of alternative-strategy mutual funds has reportedly increased by 56% since 2008.
A recent Cerulli report
predicts that exposure to alternatives will increase from the traditional 2% to 3% to 20% over the next five years.
Alternatives were attractive long before 2008 and investors invested heavily in them. But the liquidity constraints of limited partnership structures and the severe declines of the capital markets in 2008 left many with badly battered portfolios and few resources to reinvest.
So the liquidity of mutual funds, ETFs, and other structures is much more investor friendly than the limited partnerships of a few years ago.
Emerging economies have developed to a point where they now offer little in the way of diversification from developed markets with a correlation of .9. (1 signifies full correlation) Still, the Cerulli report showed emerging markets funds net inflows
at a rate of $21 billion for the year ended March 31.
Meanwhile, US equity funds saw money flow away from them to the tune of $76 billion over the same period.
Frontier markets—countries like Africa, Ethiopia, Ghana, Eastern Europe, Middle East, and South America—have taken over emerging markets as the high risk, low correlation alternative.
Analysts compare their point in development to Brazil and China 10 to 15 years ago. And the correlation of frontier markets to more developed markets is .6.
But these markest also are quite vulnerable to geopolitical risks and much of the population still lives in extreme poverty. So investors should carefully weigh the risks and perhaps invest only a small portion of their opportunistic portfolio allocation.
The potential for growth is definitely there, although emerging markets are still offering significantly better returns. Year-to-date, the MSCI Frontier Markets Index
was up .99% year to date through May 9 while the MSCI Emerging Markets Index was up 6.71%.
Should your clients abandon stocks, bonds, and cash for alternatives, emerging markets, and frontier? Probably not. But you can help them develop smart strategies such as a core and spoke approach for taking advantage of the above-market returns and risk management possiblities they may offer.