Financial advisors increasingly have turned to alternative investments for their clients to achieve low correlation to traditional stocks and bonds, reduced portfolio volatility and decent returns. But are they getting the real thing when they access alternatives through ’40 Act funds that have proliferated in recent years?
“It comes down to three things: leverage, liquidity and diversification,” said Eddie Lund, vice president of business development at Gemini Fund Services. Lund spoke on a panel today at the fourth annual Innovative Alternative Investment Strategies Conference in Denver. Financial Advisor and Private Wealth magazines host the conference.
Hedge funds employing alternative strategies can juice returns by loading up on leverage to gain additional exposure to various asset classes. But ’40 Act portfolios can’t have more than one-third leverage. “But that doesn’t mean they can’t get additional exposure, Lund said.
Gemini helps investment advisors create their own ’40 Act funds, and Lund said most of Gemini’s advisor clients who create alternative products in the ’40 Act space can significantly add more exposure to a particular sector by using options, futures or swaps.
Other restrictions on ’40 Act funds include limitations on holding illiquid assets, as well as diversification requirements to avoid overly concentrated portfolios. These don't apply to hedge funds.
Nonetheless, the performance difference among various alternative strategies—such as global macro, event-driven, long/short equity and arbitrage—between hedge funds and ’40 Act funds is rather small, said John Cadigan, national sales manager at Arrow Funds.
“The liquidity premium on registered versus non-registered products across the board is about 1 percent,” he said, adding that it differs depending on the strategy. For example, investors give up 1 percent in returns with long/short strategies in return for greater liquidity, while event-driven and market-neutral strategies have a wider differential of more than 2 percent.
On the ’40 Act fund side, Cadigan said advisors are expressing interest in funds pursuing long/short equity strategies, as well as multi-strategy funds that enable them to partake of various alternative approaches without having to have do dig too deep into each strategy. “There are a lot of nuances between the different strategies,” he said, adding that advisors like the array of strategies within the multi-strategy group.
Cadigan said he’s also seen a lot of interest among advisors in non-traditional yield-type products.
Some purists hold that hedge fund-style alternative strategies in ’40 Act mutual funds are “hedge fund lite” products that can’t fully replicate the results of full-bodied alternative strategies offered by hedge funds because of restrictions placed on them by the Investment Company Act of 1940.