At times, the mark of a good financial advisor is the ability to accept a strong idea…and then wait patiently for it to emerge in the marketplace. That may be the case now with the concept of adding "alternative investments" to asset allocation programs. (For purposes of this article, we'll define "alternatives" as hedge funds and managed futures programs.)

Hundreds of alternative programs are searching for financial advisor distribution, and they make a semi-compelling case: If you include alternative investments as one asset class in your allocation model and put 20% into it, overall portfolio volatility will be reduced and risk-adjusted returns will increase, based on historical results.

Currently, the case is just "semi-compelling" due to five issues these programs may not mention:

1. Alternatives are expensive. It's possible for clients to pay total fees on that 20% allocation equal to fees on the other 80% of assets combined.
2. Alternatives are tax-inefficient for non-qualified accounts, since most programs are structured as partnerships and pass through trading gains or losses.
3. Since many individual programs require $1 million or more of financial net worth and minimum investments of about $200,000, access is limited.
4. Alternatives are not transparent, so advisors can't independently monitor what's happening. Also, alternatives pose relatively high "business risk."
5. Most alternative programs haven't yet figured out how to compensate advisors adequately.

If you believe these issues are valid today, hold your ground and wait. Since October of 2002, a new dynamic has been at work in the alternatives industry, creating improvements in all five areas. This dynamic is the concept of passive investing-;indexing-;applied to alternatives. As the trend continues, you will soon be able to add alternatives confidently to your allocation model, with less concern about the issues above.