How will you help them navigate the liquid alternative maze? Here are five ideas.

Idea #1:  Take charge of client education.

Your clients need educational information to understand alternatives, and you are its best source. Here's proof: In February, Invesco released findings from a survey it sponsored with Market Strategies International of high net worth (HNW) and affluent investors who work with a financial advisor. The survey found:

• 77 percent of affluent and HNW investors are not familiar with the term "alternative investment."
• Of the remaining 23 percent, just 4 in 10 currently use alternatives. Among these, alternatives account for just 16 percent of total investment assets.
• Only 10 percent of investors said they have a high-level understanding of the alternative category.
• Among alternative users, 65 percent of HNW and 52 percent of affluent investors named their advisor as the primary driver of the decision to add alternatives.

None of these findings are surprising. They just reinforce the fact that clients expect advisors to lead them through the alternatives maze. The huge and growing promotion – some might say "hype" – surrounding alternatives makes a trusted advisor's role even more important.

Idea #2: Focus first on the "big five" categories.

Of the 13 alternative categories tracked by Morningstar, five are mainstream. The table below shows these five ranked by assets and net inflows for 2013 and January of 2014. (Both mutual funds and ETFs are included.)

For details, see http://corporate.morningstar.com/US/documents/AssetFlows/AssetFlowsJan2014.pdf

Of the eight alternative categories not listed above, seven are trading-related and dominated by inverse or leveraged ETFs. They remain relative insignificant in terms of assets. The eighth category consists of about 80 actively managed bear market funds, a specialized niche.

The five large categories shown above account for about 90% of all liquid alternative assets and 2013 inflows. The top three categories shown above had strong positive inflows in 2013, while Multicurrency and Managed Futures lagged. However, 2013 was not a year when most investors were concerned about higher inflation. Multicurrency and Managed Futures have special portfolio applications in inflation-hedging.

Note: In some analyses, Morningstar includes Nontraditional Bond as an alternative class. It is the 23^rd largest overall category, with $123 billion of AUM as of 12/31/13.

Idea #3: Decide where alternatives fit into your investment process.

Morningstar defines an alternative investment as one that aims to produce positive risk-adjusted returns over a reasonable time frame, with a relatively low correlation to traditional investments.

If your goal is to implement an alternative allocation with a "one-stop shop" fund, look in the Multi-Alternative category, say the firm's alternative analysts. To add funds selectively or opportunistically, Morningstar suggests that you:

• Choose Market Neutral or Multicurrency funds for clients who have a lower risk tolerance or want to emphasize diversification. Returns are generally lower in these categories, and they have relatively low correlations with traditional equities.
• Choose Long/Short Equity or Managed Futures funds for clients who can tolerate more risk and volatility.

In the past, most advisors have recommended re-positioning assets into alternatives by reducing equity exposure. Since equities have been the biggest source of portfolio risk and volatility, this strategy has helped to reduce overall portfolio risk. However, Morningstar says this idea may need rethinking in the current environment because "more risk will be coming from bonds in the future."

For more on Morningstar's guidance from Active Funds Research Director Michael Herbst and Alternative Analyst Josh Charney, see this insightful presentation in PDF format: http://www.insidersforum.com/sites/default/files/users/InsiderForumLLC/Presentations/Insiders%20Forum%20-%20Morningstar%20Slides%20%281%29.pdf

Idea #4: Look behind the labels.

Within each category, investment strategies and style can vary widely. For example:

• Some Long/Short Equity funds use leverage on the long side of the portfolio while others do not. Leverage can make a Long/Short Equity fund more volatile than the S&P 500 Index, in extreme cases.
• Betas of Long/Short Equity funds typically range between 0.3 and 0.8, but some managers are more aggressive than others in tactically managing net equity exposure. When managers try to aggressively time these adjustments, they may be introducing an additional source of risk, especially in volatile markets.
• Although Morningstar defines a Market Neutral fund as one with beta of between -0.3 and 0.3, some funds in this category give managers the flexibility to exceed the top end of this range. Look closer to learn how much Market Neutral managers try to isolate alpha (the value added by managers) while neutralizing beta (stock market systematic risk). Market Neutral funds that rely partially on beta can blur into the Long/Short Equity category.
• In evaluating Multi-Alternative funds, focus on whether the manager's expertise is in 1) selecting external managers and sub-advisors; or 2) managing money in-house. Also, ask whether they allocate money to managers and styles strategically or tactically.
• Some Multi-Currency funds maintain long exposures to mixed foreign currencies vs. the U.S. dollar. These are the most effective for hedging against U.S. dollar depreciation. Other funds follow a carry strategy, in which they go long higher-yielding currencies and short lower-yielding currencies, whatever they may be.

Idea #5: Don't lower your fund selection standards.

Since the liquid alternative space is so dynamic, it's a good idea to be open-minded to new funds and unfamiliar managers, but it doesn't mean you need to lower your tried-and-true selection standards. For example, suppose your method is to select mutual funds with: 1) manager tenure of at least five years; 2) expense ratios of not more than 1.50%; 3) Morningstar performance ratings of at least four stars; and 4) at least $100 million in assets under management. What liquid alternative choices do you have?

You will have five choices in the Market Neutral category, including funds offered by AQR, Arbitrage, Calamos, Merger and PIMCO. You will have three choices in the Long/Short Equity category including funds from Aston/Anchor, Diamond Hill and Wasatch. However, there are fewer or no funds meeting these criteria in the other large categories.

Currently, five large liquid alternative funds have achieved "critical mass" with more than $5 billion in assets under management. They are:

1.     Mainstay Marketfield, Long/Short Equity, $19.9 billion

2.     AQR Managed Futures Strategy, Managed Futures, $11.1 billion

3.     Gateway, Long/Short Equity, $8.2 billion

4.     Pimco Emerging Markets Currency, Multi-Currency, $6.6 billion

5.     Merger, Market Neutral, $5.1 billion

Category average expense ratios are relatively high in the Managed Futures (2.31%), Long/Short Equity (1.91%), and Market Neutral (1.70%) categories. They are lower in the Multicurrency category (1.28%).

You can screen alternative mutual funds to find that meet your criteria by using Morningstar's Fund Screener tool at:

http://screen.morningstar.com/FundSelector.html

One Final Idea

Even if you don't want to recommend specific liquid alternative funds or strategies yet, this is a good time to start talking to clients about how these funds work and potentially can enhance a portfolio's risk/return profile.

A huge wave of liquid alternative marketing is about to descend on investors. Your clients will be looking for education and guidance, and you are the best person to help them.