Alternative investments should comprise as much as 20%, 30% or even 50% of a client's portfolio, according to an online panel of analysts and portfolio managers hosted by Envestnet.

Alternative investments, which Envestnet's chief investment strategist Tim Clift defines as anything that uses leverage, shorts or derivatives, have grown dramatically in popularity over the past three years. According to a report by Boston-based financial research firm Cerulli, demand nearly tripled between 2008 and 2011 as assets under management rose from $78 billion to $214 billion compared to 55% overall growth in the mutual fund industry. Firms launched a record 72 new alternative mutual funds in 2011.

"It is really one of the fastest growing areas in the mutual fund space," Clift said in an online conference call, sponsored by Envestnet, a Chicago-based provider of wealth management   for financial institutions and advisors.

 That growth is due, in part, to the fact that barriers to entry in alternative funds have gone down, and these strategies have become more accessible for investors of all levels over the past five years.

Once available mostly to hedge fund clients, alternatives traditionally had performance-based fees plus fairly high expenses, complicated K-1 tax reporting, high minimum accreditation and long lock-up periods where investors were unable to access their funds. In today's alternative scene, a number of mutual funds now feature better liquidity at lower minimums, lower fees and more transparency. "They're much more accessible than they were five or six or seven years ago," Clift said.

Another reason for the boost in the popularity of alternatives is also their ability to help investors maintain returns through volatile times, the panel said. According to Clift, when equity markets and the S&P 500 dropped dramatically (around 40% from 2000 to 2002) hedge fund indices were down by a much smaller 10%.

"That's one of the bigger benefits of alternative investments, not the only one, but one of the bigger [ones] is that you can protect the downside or reduce the downside exposure to volatility," Clift said.

Something to keep in mind, Clift cautioned, is that while volatility was being reduced, alternatives did give up some on the return side when compared to some long term traditional investments.  "Don't expect alternatives to be the best of both worlds," he said. "Generally in very strong up markets, these hedge funds or alternative investments tend to trail, but it's when the markets begin to fall apart that these things really shine in a portfolio."

However, according to Robert Kea, portfolio manager at Putnam Investments, advisors are still likely to make more money in the long term if they can leverage against volatility. "You will actually make more money making less on the upside than losing more on the downside," he said.

As such, all three of the panelists recommended at least a 20% allocation in alternatives. But Kea put that percentage as high 50%, as long as the client feels comfortable with that allocation. He defended that percentage on the grounds that the global economic outlook will "probably" remain volatile and it will be "more important than ever to diversify your clients," he said. "Often the opportunities available to the investor are not, 'what's cheap what should I be buying,' it's sometimes 'what's really expensive, what should I be shorting.'"

Kea acknowledged that 50% is a large chunk and words like leverage and shorting can make some clients nervous. Yet when compared with a traditional 60/40 split between stocks and bonds, adding alternative investments can dramatically reduce exposure to market swings, he said.  "What investors sometimes don't realize is that in a 60/40 portfolio, 90% of the risk is coming from stocks,
 Kea said. "It's really not a diversified portfolio. Especially in these volatile periods, stock market performance is going to completely dominate that portfolio."

Most investors going into alternatives choose to move money mostly from equities, but some from fixed income as well, Christine Johnson, director of alternative investments at DWS Investments, said.  "Certainly investors are seeing that the fixed income opportunities that they've had in their portfolio for the last 25 years, is coming to an end," she said. "So we are seeing investors take the allocation from both fixed income and equities. We really do believe in this 20% as a base case and up to 30%, and every investor? -- whether they're conservative, moderate or aggressive -- should have an alternative allocation."

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