Why Investors Are Pouring Into Alternative Investments

These strategies can offer diversification and downside protection.

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A recent report shows that investors are clamoring for more options for their portfolios. In 2009, investors poured approximately $75 billion into alternative-style mutual funds and exchange-traded funds in the U.S., according to a report released by asset manager SEI and research firm Strategic Insight. The largest inflows were seen in long/short, market-neutral, commodity, and currency funds.

"Alternative strategies have the prospect of offering non-correlated returns to diversify some of the risks that investors see in their portfolio of traditional long-only products," says Ben Alpert, hedge fund analyst with Morningstar. "That's why you see the trend of why they're going in that direction."

[See U.S. News's list of the 100 Best Mutual Funds for the Long Term, and use our Mutual Fund Score to find the best investments for you.]

Recently, U.S. News spoke with Adam Patti, CEO of investment firm IndexIQ. His firm specializes in alternative strategies. Excerpts:

How would you define alternative investments?

Alternative investments are typically anything other than traditional asset classes like stocks, bonds and cash. There are different definitions of alternatives. Some people include commodities. Some people don't. … The institutional marketplace has been using alternative investments for many, many years, and increasingly so over the last 10 years, specifically for diversification in volatile markets. The problem is that retail investors have not had access to these types of strategies, so they had to be stuck with portfolios that would really sway with the winds of the marketplace because they were in stocks, bonds and cash. 

What role can alternative investments serve in a portfolio?

What alternative investments do is really just provide different performance characteristics to your traditional asset classes and provide that diversification to reduce the volatility of your overall portfolio. In tough markets, the bottom line is that you're looking for downside protection, and that's what alternative investments are for.

What is your company's strategy?

Our tagline is democratizing alternatives. Why should institutions and only rich investors have access to the types of products to protect them in tough markets? That's the basis upon which we founded the company—to provide the institutional class with investments strategies that institutions have had for many years and to provide them for more investors. Most importantly, we provide them with full transparency, full liquidity and low cost. That's the key because many times alternative investments like traditional hedge funds are not liquid, certainly not transparent and are very pricey. … Everything we do is index-based so we don't have portfolio managers making arbitrary decisions on what we buy and sell. Everything is based on an index and 100 percent transparent.

What is the strategy behind your flagship mutual fund?

In 1984, there were 84 hedge funds. Today, you’ve got 9,000 hedge funds. There are almost as many hedge funds as there are mutual funds. And as we know in the mutual fund market, 75 percent of active managers underperform their benchmark every year. It's the same thing in the hedge fund market. We're not against hedge funds. We think they're great for diversification. It's just that they can be replicated. When you look at them in aggregate, what they're investing in is common asset classes because that's what they have at their disposal. [Hedge funds are investing in] stocks, bonds, cash, real estate, commodities and currencies. There are only so many asset classes you can invest in. Hedge fund replication is nothing more than identifying the common asset class exposures that hedge funds are investing in and using liquid securities in the portfolio to mirror those strategies. … It's based on a lot of academic research to show that you can replicate the risk/return characteristics of hedge fund investing using common asset classes that everyone has access to that are very liquid, and you can do so with full transparency and with low fees.

What makes up your fund's core holdings?

ETFs are the core holdings of our hedge fund replication products. The reason we do that is because, again, it's all about holding all core asset exposures, and ETFs are a very efficient way to gain access to those asset classes. Instead of holding hundreds of individual stocks and bonds, we just hold a very core, concentrated portfolio of 20 or so ETFs to represent all those asset classes. … There are many different types of hedge funds out there, so what this product does is it provides investors access to really what a fund of funds would do. In other words, it's providing access to six underlying hedge fund strategies. Those six strategies compromise around 80 to 85 percent of overall hedge fund assets.

Give an example of one of these six strategies.

One of the strategies is emerging markets hedge. … What emerging markets hedge funds do is they're focused on emerging markets so you can imagine what they do. They're investing in emerging markets equity, and emerging markets debt, and they're probably investing in commodities because many of those markets are commodity-driven economies. They're probably investing in some type of currency and those four asset classes comprise most of what these guys are doing. That's what comprises our emerging markets hedge index, which is a component of our mutual fund. The allocation to those six changes monthly depending on what's going on in the marketplace.