The multiyear market rally that started after the global financial crisis had a far-reaching impact on investors all over the world.

By mid-2015, the S&P 500 Index was almost 250% above its March 2009 bottom on a total-return basis. For the MSCI World Index (in local-currency terms), the gain was 185%. Global central banks fueled the rally by running unprecedented programs of monetary easing.

In that environment, even passive exposure to stocks and bonds was very effective. Beta—returns from broad market movements—ruled. With few exceptions, anything that diversified portfolios away from, or even reduced, stock or bond exposures cost investors in terms of missed returns.

This environment created headwinds for alternative investments.

Alternative strategies are designed to reduce broad market exposure and lean more heavily on alpha—outperformance using security selection or other means to generate returns. It's this lower market exposure that offers protection in difficult markets; historically, alternatives have been largely effective in doing this. However, market downturns in the recent past tended to correct quickly, and the stumbling block for alternatives was their lack of upside participation as markets continued to surge forward.

How much was the deck stacked against alternatives? The S&P 500 Index returned more than 32% in 2013; a long/short equity strategy with a beta of 0.5 (half as sensitive as the market) would have returned just 16% from market exposure. That shortfall required alternatives to generate enormous amounts of alpha—year after year—just to narrow the gap.

At a time when alpha potential was very low, closing that gap was a big challenge. In addition to strong market returns, the beta trade featured unusually low volatility and low dispersion (Display above)—smaller differences between asset returns. This environment made it hard for alternatives to produce enough alpha to make up the ground lost from lower beta exposure.

Market Landscape Improving for Alternatives

The good news for alternatives is that the strong wave of market returns couldn't last forever. In fact, it seems to be subsiding. Since June 2015, the S&P 500 has returned just 6.2% and the MSCI World Index 2.3% (in local-currency terms) annualized, with sell-offs sparked by growth concerns about China, plunging commodity prices and the Brexit shock.

Volatility has been a challenge, too. We've seen more volatility spikes in the past two years than in the previous 20 years. During many of these periods, alternatives did what they were supposed to do: provide diversification and downside protection. Downside protection historically has been a key element that defined alternatives' return path—and has driven their historical success.

In terms of upside, we expect most markets to deliver below-average returns in the years ahead. Volatility is likely to increase—especially if and when US interest rates start to rise. Higher volatility tends to create more dispersion among asset returns, increasing security-selection opportunities to generate alpha.

Downside protection historically has been a key element that defined alternatives' return path—and has driven their historical success.

 

In other words, we think we're moving into an environment in which alternatives will tend to thrive, and which could reintroduce their benefits to investors. Over the last 25 years, alternatives have produced a strong risk/return profile that can make them effective enhancers for traditional portfolios.

Before digging deeper into how to deploy alternatives, it helps to clarify what they are. Alternatives have grown into a diverse universe that includes asset classes, illiquid investments and a wide range of strategies.

Alternative strategies range from event-driven to global macro and long/short equity. Here, we'll focus mainly on long/short strategies, because investors' experiences with them illustrate the recent challenges—and confusion—with alternatives.

Diverse Experiences with Alternatives

As with any investment, investors' experiences with alternatives haven't been uniform. We think it's possible to segment investors' recent alternatives experiences into three categories:

• "Alternatives are doing what I need": These investors have been largely satisfied with how alternatives have performed in their portfolios. In their assessment, alternatives have delivered downside protection and diversification.
• Solid Rising-Rate Defenses. In general, private credit returns have a low correlation to changes in government bond yields, meaning they're less rate sensitive than many core fixed-income strategies. Also, direct loans to midsize companies or for commercial real estate are typically floating rate, allowing returns to rise as rates do. Investments backed by real physical assets, with cash flows linked to LIBOR-based indices, can provide an effective hedge in a rising-rate environment. Other sectors, such as residential mortgages, are fixed rate, but they typically pay a yield premium to cushion the impact of a rate rise.
• "Alternatives haven't been great, but I get it": These investors recognize that alternatives' performance hasn't been favorable in the past few years. But they also acknowledge that they shifted some of their beta exposure into alternatives in a beta-driven market.
• "Alternatives haven't worked": This group of investors is wondering what happened with their alternative allocation in the beta rally. As they see it, allocating to alternatives robbed performance from their portfolios.

These diverse attitudes were shaped by three factors: the specific point when investors allocated to alternatives, how clearly they set their expectations and how well they evaluated the options to allocate one or more alternative strategies to their portfolios.

The Challenges of Alternative Selection

One challenge in choosing an alternative strategy lies in the way they're categorized.

In the US, Morningstar has worked to provide a framework around alternative strategies, adding categories and a style box. However, strategies with shorter track records aren't included. In Europe, Morningstar has created more defined alternative categories, but no longer provides category rankings.

To compound the challenge, managers who run alternative strategies within those categories can use a wide universe of investments, tools and approaches. As a result, selecting an alternative strategy is in many ways more complicated than choosing a stock or bond strategy.

The rapid growth in alternatives has brought more investors face-to-face with this challenge. Many investors are still becoming familiar with the metrics and mind-set needed to choose the right strategies. They've been drawn to the idea of alternatives without clearly defining the behavior in an alternative that would best complement their portfolio and objectives.

These complications have left many investors convinced that alternatives can't do what they want them to do. It hasn't helped that the long market rally turned the typical experience of strong up/down capture—a signature of alternatives' success—on its head.