David Diesslin has been using alternative investments for some 20 years now, so he's not surprised that hedge funds, private equity and the like are the new rage among return-hungry investors.
Although these vehicles can seem scary to some, Diesslin learned long ago that, with a good amount of research and caution, alternative investments are a land of opportunity.
But it's an investment arena that can also be a minefield to the unwary advisor, and that's what makes Diesslin uneasy. "My fear is a lot of people going there don't understand the implications," says Diesslin, president of Diesslin & Associates in Fort Worth, Texas. "It's the herd mentality. Kind of like, what do we talk about? Large caps sucked. Bonds are boring. Small caps aren't going anywhere. Where's the sex? What can we sell?"
Some worry there's something distinctly familiar about the rush toward alternatives, a place that resides somewhere between the limited-partnership debacle of the 1980s and the dotcom mania of the late 1990s. "Parts of the hedge fund world are going
to be the next bubble," predicts Charles D. Haines Jr. of Charles D. Haines LLC in Birmingham, Ala.
Yet Haines is a proponent of alternative investing. He got his firm's high-net-worth clients involved in alternative products-primarily private equity, real estate and managed futures products-six years ago. "Given the last two years, thank goodness we did," he says.
Yet he says his firm's entry into alternative investing took work and requires intensive on-going due diligence. The firm searched out people in the business, developed networks and formed a study group with several other firms before taking any action.
As others involved in alternative investing attest, Haines says it is as much about investing in people as it is different vehicles. "We spent a lot of money finding our network," Haines says. "It's a good old boy and good old girl network. It's who you know in gaining access. The biggest issue is gaining access."
That's why, to this day, Haines hasn't dabbled in hedge funds. He finds the industry to be too murky, the availability of data too sparse, to make solid decisions. The growth of the business from about 300 funds to more than 6,000 with $500 billion in assets is also a concern. It's also why he's concerned that too many advisors may make a hasty move into alternative investments-potentially creating a stampede that could inflate expectations and value.
"Too much money is going after the same stuff," he says. "There are too many conversations in the scrub room. It's a sexy part of investing now."
A study by Undiscovered Managers, a firm that is one of many introducing a new hedge fund of funds platform, last year found that there are indeed benefits to including alternative investments in a diversified portfolio. Looking at data spanning 1990 to 2000, the study found that a portfolio with 25% assets in alternative investments outperformed a traditional aggressive-growth equity portfolio by more than 200 basis points.
Many suspect the U.S. financial markets are now entering an era that will be characterized by low returns from financial assets like stocks and bonds. That makes the argument for a core portfolio of mutual funds and managed accounts supplemented with a carefully selected satellite portfolio of hedge funds and other vehicles look even more compelling. In particular, the increased flexibility of hedge funds, coupled with the high-return potential of venture capital, seems irresistible when compared with a pricey stock market sitting in a financial-reporting minefield.
At the same time, the Undiscovered Managers study cautioned that performance among alternative investments varies widely from manager to manager, and in many cases, the workings of a fund are shrouded in secrecy. "They are analogous to prescription drugs," the study says. "Used correctly, and under the guidance of a knowledgeable professional, they can create incredibly positive outcomes for their users. Used incorrectly, they create disasters."
The New Rage
There's definitely a buzz in the industry about alternative investing. Not that anyone is surprised by it. After two years of losses in the broad market, coming after a nine-year bull rush, investors are looking for something-anything-with an aura of promise.
Some advisors, meanwhile, are trying to inject new life into asset-allocation models that have failed to negotiate the sharp turn the market has taken the past two years. Diversification hasn't been a panacea in recent years, as the traditional asset classes have, for the most part, performed poorly. A potpourri of experts say there's still hell to pay for the run-up of values during the late 1990s and that investors can expect low annual returns of 6% or less for the broad market going forward. Advisors, meanwhile, also are feeling the squeeze from clients who are tired of hearing about relative returns, and are hungry for some absolute gains.
Since alternative investments traditionally do well during down markets, many hungry eyes have turned to these products as an alternative to business as usual. As Harold Evensky of The Evensky Group in Coral Gables, Fla., sees it, the expectations of lower returns is forcing advisors to revisit asset-allocation models that were built on over-optimistic assumptions. One new model advocates putting 80% of assets into a tax-managed index core and 20% into a "tactical satellite" that includes alternative investments.
In other words, he says, alternative investments have become a virtually essential part of asset allocation. "I definitely think any serious advisor needs to be aware of it, consider it and probably be using it," Evensky says.
The rush to alternative investments is not a new phenomenon. Hedge funds have been hot before. What's different this time around, though, is that the big guns are getting in on the action. Mutual fund companies that have subsisted on long-only strategies throughout their existences are now entering the world of long-short, convertible arbitrage and other derivative strategies, mostly through fund of funds products.
Among the companies that have announced plans to enter the alternative-investing business are OppenheimerFunds, which recently acquired fund-of-funds sponsor Tremont Advisors; Montgomery Asset Management; Neuberger Berman Inc.; Franklin Resources Inc.; State Street Corp.; Wells Fargo & Co.; Bank of New York Co.; and Phoenix Cos. Inc.
Other companies have services and platforms in the offing. Although the company has been mum on its plans, Undiscovered Managers reportedly is preparing to roll out hedge funds of funds products of its own sometime this year. So are several independent brokerages, including Raymond James Financial Services.
On the custody and clearing end of the business, advisors can expect to see alternative-investment products pop up on platforms throughout the year. Charles Schwab plans to give advisors access on its platform this year to an array of hedge-fund, private-equity and real estate offerings, says Liz Fanlo, vice president of product development and management for Schwab Institutional.
"That's where they're telling us they're most interested," Fanlo says. "They need it as a differentiator ... and they're looking for asset classes that provide a low correlation to the broader market."
All this marketing muscle and competition could lead to broader accessibility to advisors and their clients. Mutual fund companies, for example, are lowering the bar on minimum investments.
Put it all together, and it could spell more inflows into hedge funds. That's good for advisors who see alternative investments as an opportunity. But it also could put an end to the party before it even begins, some observers note.
That's because many hedge funds depend on arbitrage as a core strategy. And, Diesslen notes, arbitrage amounts to the manipulation of inefficiencies in the market. But the more money that gets poured into the market, the less inefficient it becomes.
"It's a good thing for modern portfolio theory, but a bad thing if you're a hedge fund trying to take advantage of market inefficiencies," Diesslen says.
Private Equity On Rebound?
While much of the interest has centered on hedge funds, there are some indications of a percolating interest in private-equity offerings. In other words, it seems advisors and their clients finally may be getting over the slaughter that took place in the private-equity technology sectors.
"If you get up in a crowd and say you're doing private equity, they're holding their nose, which is a good indicator it's time to get into it," says Mark Spangler, president of Spangler Financial Group in Seattle. "As far as what's intriguing right now, we find most of our opportunities are in private equity."
Private equities have their own set of issues for advisors who don't regularly use them. They are extremely illiquid, with investment horizons stretching anywhere from three to 10 years.
"It takes a lot of time for today's investments to cycle back," says Ted Weissberg, president of Venture Economics, a division of Thomson Financial, based in New York City. The payback for investors is a return that, over the long run, is generally a few hundred basis points ahead of the broader market.
Another reason the private-equity market is due for an inflow of investment is that, historically, the best time to invest is after one or two poor years. "The companies that get the investments tend to be stronger, and they tend to get funded at lower valuations," says Weissberg, who adds that biotechnology is the sector currently attracting the most private-equity investments.
As is the case with hedge funds, however, private-equity failures can exact a serious toll on investors. The Undiscovered Managers study last year cautioned investors that the performance gap between the best and worst venture-capital fund managers is huge compared with traditional fund managers. During the 10 years ending December 31, 1997, the study found, the performance gap between venture-capital managers in the first and third quartiles was 21.2%. This compared with a gap of 1.2% in the U.S. fixed-income sector and 2.5% in the U.S. equity sector.
Mark Goldberg, president of Royal Alliance in New York City, spent several years in the late 1990s on the board of a venture capital fund, and has serious reservations about advisors entering this market. "It's suitable for about 1% of the population," he says of a market dominated by giant institutions.
If clients invest in a traditional venture-capital fund, it's imperative to know the terms of their commitment. "A $1 million commitment may be drawn down over time, but they can also call your capital at any time," Goldberg notes.
Methods of calculating both performance fees and management fees vary widely, with some charging management fees on the date of the capital commitment and others on the date of the capital call, he adds. Management fees range from 1% to, in a few cases, 4%.
Different funds have different industry-concentration limits and different maturity and exit-strategy dates. Typical maturities range from five to 12 years. Like hedge funds, venture capital isn't subject to many of the regulations that govern mutual funds and securities. "The normal protections advisors are accustomed to aren't there," Goldberg explains.
Mutual Funds Feel The Heat
There's reason to think mutual funds are in the alternative-investment business for the long haul, observers say. That's because they're fighting for survival.
"Mutual funds are really having an identity crisis because they're losing dollars, and they're losing good managers," says Ronald Rutherford, an investment advisor in New York who has used alternative investments for eight years. "I think some of the mutual fund companies are trying to find a way to get it down to a lower common denominator, which is tough because a lot of these investments are restricted to accredited investors."
Advisors who have experience with alternative investments say that if advisors do their homework, they can make good use of this new generation of alternative-investment products. The fund of funds route, they say, could be particularly attractive to small firms that don't have the time or money for the due diligence that's essential when selecting individual investments.
In the hedge fund arena alone, for example, there are an estimated 6,000 funds in existence with $500 billion under management. Yet speak to hedge fund experts, and many will tell you that only several hundred are worth the risk to the average high-net-worth investor.
The reason they are known for outperforming the broad market is that managers can turn to a vast variety of techniques to extract gains: arbitrage, risk arbitrage, long-short hedging, global macro, etc. Furthermore, the funds don't fall into a neat Morningstar-esque style box. Managers can, and often will, change strategies on a dime in reaction to market conditions.
Even with due diligence, gaining access to a skillfully managed hedge fund can be like catching lightning because the good funds close so quickly.
"The good people don't need any money-they have enough," says Haines. "If you want access to them, you have to go through a fund of funds."
The bottom line, experts say, is that the risk level of hedge funds has been overplayed in recent years. But in the same breath, they will warn that funds can indeed be risky if you fall in with a bad manager.
In other words, if you stumble while navigating the hedge fund market, you may end up falling off a cliff. "Hedge funds have more ways to make money, and more ways to lose it," Samuel S. Weiser, chairman of the Managed Funds Association, said at a recent alternative investing conference held by the Investment Management Consultants Association in New York. "The opportunities are there, they're just more difficult to find."
That's why Jason Cole, of Spencer Financial Inc. in Philadelphia, says his firm proceeded carefully when it turned to alternative investments a little less than a year ago. One of the firm's initial decisions was to limit its exposure to the hedge fund universe through funds of funds offered by JP Morgan Chase Funds, he says.
The firm liked the fact that the products spread out risk among 30 managers, and provided the due diligence and oversight of a reputable company, Cole says. The funds provided an average gain of 9.02% for the firm's affluent clients last year, he adds. "It gave us a lot of comfort," Cole says. "I'm trusting the diligence of JP Morgan Chase more than anything, and their ability to get access to the best managers."
Those advisors who have only limited exposure to alternative investments, or none at all, are in some cases getting pressure from clients. Thomas Grzymala, president of Alexandria Financial Associates Ltd. in Alexandria, Va., says his wealthy 30- and 40-something clients are expressing more interest in hedge funds.
"They know about investing, and they're asking questions about such things," he says. "I'm looking more at it, and every conference I make sure I get to that lecture. I'm learning as I go along."
Grzymala hasn't ignored alternative investments, however. Seven years ago, he introduced clients to limited partnerships in oil and gas well properties offered by Five State Energy.
It was the type of investment that, on its face, Grzymala would normally have bypassed. But he happened to meet the CEO of the firm at a conference, did more research and decided it would provide a good passive income stream for his high-net-worth clients.
"I started digging around and rooting around and found quite a few people who had been investing in their partnerships for several years," he says.
Some advisors note that mutual funds that utilize hedge strategies can offer a good compromise for those worried about getting involved with pure hedge funds. Anthony Vargo, director of investment management with Legend Financial Advisors Inc., in Pittsburgh, says his firm sticks with a predominantly mutual fund format in its alternative investing.
The Merger Fund and the Caldwell & Orkin Market Opportunity Fund, recently closed, are among the funds consistently used by the firm, he says. "We want to be able to produce good and relative returns in all market environments," Vargo says. "We view these products as a way to do that."