If we hadn't fully grasped it beforehand, one of the great lessons from the financial crisis of '08 and early '09 is that the markets are risky. Like, really risky. Allocation strategies among traditional asset classes didn't provide much-if any-downside protection when nearly all asset classes went down the drain together.

So it's no surprise that alternative investments have generated lots of interest in the post-meltdown world. But the alternative universe is broad, and at times confusing.

In late July, Financial Advisor and Private Wealth magazines brought together some of the sharpest minds in the alternative investment space for the inaugural Innovative Alternative Strategies conference at the Westin Chicago River North hotel.

As the tour boats floated by along the adjacent Chicago River in the heart of downtown, more than 400 attendees discussed the ins and outs of numerous alternative strategies, why there's a need for them and how to implement them in investment portfolios.

"Now more than ever, you have to think about how portfolios are positioned for risk versus how they're positioned for returns," Marc Zeitoun, managing director and head of distributions at Rydex/SGI, said during the conference's welcoming session. He cited the massive inflows into bond funds during the past 18 months as evidence of people's risk aversion, but also said it's a strategy he deems potentially misguided because bonds could get whacked by rising interest rates.

Alternative investments could help dampen that risk "because they're not necessarily sensitive to interest rate movements and they have low correlation to equities," Zeitoun said.

And, he added, many alternative strategies have the ability to go both long and short, a helpful tack considering that the major equity indexes were saddled with flat returns and rising volatility during the past decade.

"The only way to make money in a market not moving in a secular trend is by being opportunistic on the long and short sides," Zeitoun said.

Broad Array
Session topics during the two-day conference ranged from understanding how structured notes and residential mortgage debt can fit into portfolios, to investing in currencies and researching hedge funds. One of the most heavily attended sessions was about managed futures, which are investment vehicles managed by commodity trading advisors (CTAs) who invest in a range of global futures markets. CTAs are individuals who get paid for advising others about buying or selling futures contracts or commodity options. They're regulated by the Commodity Futures Trading Commission and the National Futures Association, the self-regulatory organization of the futures industry.

Managed futures participate in about 150 markets running the gamut from stock indexes and foreign currencies to palladium and pork bellies. As one of the panelists at the session quipped, the industry isn't just about trading orange futures like in the movie Trading Places.

Proponents of managed futures say the asset class can dampen portfolio volatility by providing a broad range of vehicles with a low to slightly negative correlation to stocks and bonds. They also tout the ability of managed futures to profit in any market environment through long and short strategies.

For example, managed futures as a whole gained 15% in 2008, led by managers who invested in global macro, sovereign debt and currencies strategies. On the flip side, the collective managed futures asset class lost 8% last year as equities zoomed after early March.
With managed futures (and alternative investments in general), it's more about looking at the Sharpe ratio and risk-adjusted returns than it is about getting the highest returns. Still, by at least one measure the long-term returns on managed futures have been impressive.

A graph presented during the session showed that from January 1990 through May 2010, the CISDM CTA Equal Weighted index of managed futures turned in the best performance vis-à-vis the S&P 500 Total Return, S&P Goldman Sachs Commodity and NAREIT indexes.

Still, a bet on managed futures is a bet on the skill of the CTA who's calling the shots. For financial advisors not well versed in this area, that means doing significant due diligence on CTAs. Or, more likely, relying on companies who put together managed future programs using their own due diligence on CTAs.

"There are about 300 different trading programs out there, and within that number are the good, the bad and the ugly," said Ken Steben, president and CEO of Steben & Co., a Rockville, Md.-based company specializing in managed futures. "The single most important thing investors in managed futures can do is to select the right manager."

That, or investors can just go with one of the growing number of '40 Act funds that package managed futures-or other alternative or hedge-fund-like strategies-into tidy mutual fund or exchange-traded formats with daily pricing, greater liquidity and easier tax reporting. These funds don't have the huge investment minimums or hefty fees associated with CTAs or hedge fund managers.

The number of '40 Act funds with an alternative bent have grown considerably in recent years, but many don't have long track records and some people consider them to be "hedge fund lite" investment vehicles. "They're not quite a true hedge fund," said Cleo Chang, vice president at Wilshire Associates in Santa Monica, Calif., because there are restrictions on leverage and limits on the amount of derivatives and illiquid securities these funds can employ. It might make them less volatile, but it also reduces the attributes that can juice returns on certain alternative investments.

One asset class where the illiquidity premium plays a big role is private equity. "Private equity has gotten a bad rap the past couple of years," said Robert Worthington, president of Hatteras Funds, a Raleigh, N.C.-based company that runs a couple of private equity-dedicated funds of funds, as well as a venture capital fund. He noted that based on the Cambridge Associates Private Equity index, private equity has outperformed the public markets by 7% to 9% a year on average during the past three-, five- and ten-year periods.
Worthington believes the best private equity opportunities are in Asia, where growing economies and potentially massive population shifts from lower- to middle-class status are fueling growth and presenting enticing investment opportunities.

"That's growth capital," Worthington said, adding it's different from what's been happening in the U.S. and Europe, where private equity has been fueled mainly by leveraged buyouts. Money going into Asia, he said, helps growing companies get bigger. And expanding IPO markets in China and India provide investors with an exit strategy on their investments.

"It's not without risk, but China and India and emerging Asia are where the U.S. was 35 years ago," he said.

Playing Ball
Structured notes, a seemingly obscure slice of the alternative space, are actually a $3 trillion global market with sales on track for a record year in the U.S., according to Mike Tims, CEO of mtn-i, a London-based media company that follows the structured note and private placement industries.

Structured investments are notes or CDs with specific payout profiles based on the performance of a variety of underlying asset classes, and they are payable at maturity. Underlying assets can include equities, commodities, foreign exchange and products tied to the Libor rate that banks charge each other for loans.

"It's a way for investors to get exposure to various asset classes they normally might not have easy access to," said Jason Wilson, executive director of Incapital LLC, a distributor of fixed income and structured note products in Chicago and Boca Raton, Fla.

Among the selling points of structured products is that they give investors exposure to different types of asset classes without holding the underlying securities. They also protect principal (upon maturity) and tailor risk to the individual investor.

Their risks include the credit risk of the issuer, their lack of transparency and a lack of principal protection until maturity. Also, they are complicated vehicles.

"Some of the feedback we got [at the conference] is that some advisors are familiar with [structured products] and have experience with it, but they've struggled to fully understand it, so the more information and education they can get the better," Wilson said.
Wilson's boss, Incapital CEO Tom Ricketts, spoke at one conference luncheon about perhaps the most "alternative" investment covered during the conference-his family's purchase of the Chicago Cubs from its former owners, the Tribune Co. The Ricketts family (Tom Ricketts' father founded Ameritrade, now known as TD Ameritrade) last summer finalized the deal to buy the Cubs, Wrigley Field and a 25% stake in a local cable sports network for about $850 million.

Tom Ricketts, the team's chairman, described the arduous path to ownerdom, including a two-year bidding process and 300 official documents requiring 6,500 signatures. The family also conducted the transaction at a time when the markets were tanking and the Tribune Co. filed for bankruptcy.

"We were dealing with the insanity of the process of buying the team along with the insanity of the markets," Ricketts said.
The Ricketts' family wealth is estimated to be roughly $1 billion, which means the deal required a lot of debt financing. And on face value, the investment appears to represent a huge percentage of the family's overall portfolio.

Otherwise, the speakers at the conference were focusing on less lofty and more normal allocations to alternatives. "We recommend 10% to 40% for clients, depending on their risk tolerance," said Robert Mileff, director of alternative investments at Fortigent, a provider of wealth management solutions in Rockville, Md. "Most are somewhere in the middle."

Statistical long-term performance suggests an allocation of up to 40% across a range of alternative investments will create a well-diversified portfolio along with sufficient levels of equities and fixed income, Mileff said.

Stephanie Lang, a senior analyst in the investment department at Homrich Berg Wealth Management in Atlanta, said her firm's typical client portfolio contains about 30% in alternative investments-roughly 25% in hedged products using funds of funds or '40 Act funds, and the rest in private equity vehicles.

But as numerous speakers noted many times over during the conference, performing sufficient due diligence on the managers providing alternative investments is Job One when it comes to investing in this space.