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Subsequent to the market crash of '08-'09, many financial advisors have re-evaluated some of the basic investing truths they've held to be self-evident, such as modern portfolio theory (MPT). While few doubt the merits of diversification, which is the foundation for MPT, more advisors are seeking a broader mix of alternative asset classes that are less correlated to traditional stocks and bonds and, in theory, less prone to the gut-wrenching volatility swings that have seemingly become the norm of late.
And for some advisors and their clients, the recent flash crash hammered home that point. "It's almost good to have those events to use as examples of why we own them [alternatives] in the portfolio," says Daniel Roe, a principal at Budros, Ruhlin & Roe Inc. in Columbus, Ohio. "It's not about keeping up with the upside of equities in bull markets, it's about downside protection and the chance to outperform bonds over the next few years."
Roe says all of his firm's clients get an allocation to alternatives through a combination of one of four different strategies they employ via three open-end, or '40 Act, funds and one private fund.
"We don't force these down clients' throats," Roe says. "They can exclude them if they want. But we educate them so they'll hopefully better understand these positions over time."
Alternative investments come in many different shapes in the form of hedge funds and hedge-style approaches that include long-short, event driven, market-neutral, global macro, merger and convertible arbitrage, relative value, directional/tactical, managed futures, distressed debt, short bias and options strategies. Many of these are long-term, illiquid strategies.
Long the domain of institutional investors, as well as qualified individual investors with the deep pockets to pay minimums ranging from $1 million to $5 million, the alternative space has expanded in recent years thanks to the growing number of '40 Act mutual funds that have brought alternatives to the masses through low-cost vehicles with daily liquidity.
These funds come with restrictions such as limits on the amount of leverage and illiquid securities they can use, which cuts into their potential returns. On the flip side, it also limits their potential losses since they're designed to be less volatile than pure hedge funds.
According to a recent study from SEI and Strategic Insight, the U.S. alternative mutual fund and ETF space grew from $90 billion in assets at year-end 2008 to $168 billion at year-end 2009. There are now roughly 400 such funds in the U.S.
Don Wilson, partner and director of portfolio management at Brightworth in Atlanta, says the wealth management firm started using alternatives in 2003 because it was dissatisfied with how stocks and bonds performed after the tech wreck. "We saw that alternative strategies did well during that period, and we wished we had some of that in our portfolio," he says.
Brightworth started out with a mutual fund employing a long-short equity strategy. Since then, Wilson says, it has beefed up its alternative mutual fund offerings across a range of strategies including tactical allocation, real return, inflation-protected, hedged equity, market-neutral and distressed real estate.
And along with mutual funds, Wilson says Brightworth invests in limited partnerships via funds of hedge funds. These include long-short, distressed debt, global macro and various arbitrage strategies.
"They've given us the returns we're looking for over full market cycles," Wilson says.
Regarding due diligence, Wilson says '40 Act alternative funds are fairly easy to research because there's a publicly traded universe to compare them against peers and to identify managers' track records.
But as Wilson and others know, performing due diligence on funds of funds is more difficult. For starters, there aren't reams of public data to pore over because a lot of hedge funds don't report their numbers.
"A lot of the best managers aren't focused on gathering assets," says Stephanie Lang, senior analyst in the investment department at Homrich Berg Wealth Management in Atlanta. "They're very protective of their information and they aren't required to report to databases. To get more granular information, you have to get it from the manager."
She says the typical portfolio for a Homrich Berg client comprises roughly 30% alternative assets. Of that, about 25% are in hedged portfolios comprising funds of funds or '40 Act funds. The rest, as much as 7%, is in private equity-like vehicles such as a private real estate fund or a natural resources fund.
Lang says her firm has found good fund of hedge fund managers through other investors. At times, funds contact her firm seeking investor money. She says hedge fund marketing people all claim to represent great managers, so advisors planning to invest in the space need to dig in and do serious due diligence.
With funds of funds, Lang says her research is focused on the people who select the underlying managers. "After all of the fraud of the past couple of years, it's become really important to understand their operational due diligence," Lang says.
These outfits should have a separate team doing operational due diligence that both verifies all of their third-party service providers and follows the flow of money to make sure all of it is there.
"A lot of the high-profile frauds occurred because managers were using affiliated or fictitious service providers," Lang says.
Regarding private investment managers, that's a tougher nut to crack in terms of getting access. Lang says one way to do that is to work through a placement agent who does fund raising for private investment groups. That said, a lot of successful private investment groups don't use placement agents because they don't need help to raise money.
Diligent, in-depth research is a must before investing with private funds. "To screen managers, we'll get their offering documents, assess their strategy, market opportunity, team and track record," Lang says. "If they still look attractive, we'll move forward with additional due diligence."
For example, she adds, "if we look at an energy manager and they buy oil and gas wells, we ask who's making the decision on buying the wells and what's their experience and track record. And what're the income risks from the wells and what are they doing to hedge that if appropriate?
"We focus a lot on the downside," Lang says. "They also have to have attractive enough returns to lock up money for ten years."
Worth The Price?
Michael Reed, president of M.J. Reed Investment Consulting in Bridgewater, Conn., says a lot of folks got interested in alternative investments several years ago thanks to press coverage of the investing prowess at the endowments for Harvard and Yale universities, both of which were heavy into alternatives. But he says people might've jumped in at the wrong time.
"What happened in 2008 took a lot of wind out of the sails of what people expected," says Reed, a former hedge fund manager in Morgan Stanley's proprietary trading group who recently set up his own RIA. He says most hedge fund strategies-managed futures was a noticeable exception-finished 2008 in the red. Various alternative strategies might have outperformed the overall markets during the crisis, but Reed questions whether their relative outperformance justified their high fees.
Reed also says that hedge fund returns have converged toward traditional asset classes as alternatives increased in popularity, a situation making it harder to exploit some of the inefficiencies that made them potentially profitable in the first place. "Convertible arbitrage is a classic example of a strategy that used to be highly profitable but where most of the alpha has gone away the past five or so years," he says.
"Given their fee structures, I don't know if they have the alpha to overcome the fees they charge," Reed says.
Still, judging by the growing popularity of hedge-like strategies, it's an investment strategy in demand. And based on the experiences of the advisors interviewed for this story, alternatives can play a constructive role in portfolio diversification, provided one does research and allocates them properly.
"Alternatives aren't for everyone," Lang says. "We wouldn't do it if we felt it wasn't appropriate for a client in terms of their liquidity and income needs.
"It's hard to time these things," she adds. "We want people to do multiple funds over multiple years to get good diversification."