Financial Advisor IQ – Advisors Hedge Bets by Talking Alternatives – Financial Advisor IQ (registration)

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With a Donald Trump administration expected to push for fiscal stimulus and the Federal Reserve hinting at several more rate hikes in 2017, bond prices are under pressure.

To some veteran portfolio managers, that’s creating a perfect environment to bring up alternative investment strategies. In end-of-year reviews, many chief investment officers at major RIAs tell FA-IQ they were steering clients to temper expectations about fixed income returns over the next several years.

At the same time, such contrarian advisors are exploring with more investors opportunities to diversify long-term asset allocation plans by tapping into a fast-evolving U.S. alternatives marketplace.

“If your portfolio is constructed in a way where bonds are used as a hedge against stock market volatility, then you could be leaving your clients vulnerable,” says Randal Golden, cofounder of Vivaldi Capital Management in Chicago, which manages nearly $2 billion.

For most of the past few years, alts funds have been laggards. Of the eight different types of alternative funds covered by Morningstar, none posted positive returns in 2015. As of late 2016, the Chicago-based investment researcher lists two types under water — bear market and managed futures. Most of the rest were barely profitable.

“We’re telling clients that it’s going to be increasingly important over the next several years to think about investing as a three-legged stool — stocks, bonds and alternative assets,” Golden says.

So he’s planning on increasing allocations to alternatives early in a new year.

“Our view of allocating to hedge funds is to search for managers who don’t derive returns from market beta,” Golden says. “We don’t want to own funds that make bets on the market’s direction.”

Instead, he focuses on non-correlated assets. Those include market-neutral strategies and managed futures funds. Vivaldi’s Brian Murphy, who specializes in building customized alternative strategies for families with $5 million or more of investable assets, is also seeing greater opportunities to diversify client portfolios in coming years through arbitrage funds.

These hedging strategies seek to arbitrage announced merger deals. Murphy is also warming to managers who look to benefit from mispricing opportunities in a more niche and nuanced closed-end funds marketplace.

“Unlike market-neutral or long-short funds, arbitrage managers aren’t dependent on which direction stocks or bonds move at any given time — these offer a fairly unique form of diversification,” Murphy says.

Mark Armbruster, president of Armbruster Capital Management in Pittsford, N.Y., is also bullish on alts funds in 2017 and beyond.

But he’s still cautioning clients at his independent RIA, which manages $300 million, against becoming too swayed by alts’ allure.

In the past two decades, Armbruster’s research shows that major indexes tracking broad cross-sections of alternative investment strategies are showing a “fairly high” 75% correlation to the blue chip stock S&P 500 index.

“That’s not an indictment of all managers who use some sort of hedging techniques,” he says. “It’s just that you have to be very selective about which funds and what management teams you’re hiring.”

One of his top picks heading into a new year are reinsurance funds. Part of such exposure for his clients include so-called catastrophe bonds, which are issued to protect against natural disasters.

Armbruster also sees plumper yields and better overall returns than traditional fixed income funds through an asset class known as “quota shares.” These funds invest alongside global reinsurance companies. “So we’re broadening our clients’ exposure to alternative insurance markets even more than just buying catastrophe bonds,” he says.

The funds he prefers in these areas were returning in 2016 around 6% net of fees through November, much better than any of Morningstar’s sub-groupings of alts funds.

Mark Armbruster

“And this has been a down year,” Armbruster says. “We typically tell clients that this asset class can be expected to produce total returns in the 7% to 8% range over time with less correlation to the broader market.”

No matter what happens in 2017, advisor Thomas Bartholomew plans to keep long-short and managed futures strategies as permanent parts of his clients’ investment plans. “We see liquid alts as a good way to help soften their ride over time and keep them invested in markets,” says the FA, whose Worcester, Mass.-based RIA manages nearly $1.5 billion.

With the S&P 500 “fully valued,” he expects such “shock absorbers” to be even more valuable to clients in 2017. Along those lines, he’s suggesting investors stick with active managers rather than index-hugging mutual funds and ETFs.

“We’ve seen the best results for our clients over the longer-term from liquid alts managers who deal in the actual securities — they don’t use derivatives or other types of synthetic investments,” Bartholomew says. “These types of funds seem to have more flexibility to truly hedge their positions, something we think is going to be increasingly important as 2017 unwinds.”