By Ed Meek
Back when I started my firm six years ago I had advisors question if my focus on alternative investments was too narrow for the type of practice I wanted to grow. This is no longer the case. Advisors have gone from barely conceiving of alternative investments as an option for their clients to seriously considering which of the many and multiplying strategies are most suitable for their clients.
I recently sent out a question to several fellow investment advisors and family office peers asking what they perceived to be some of the top trends in the alternative investment space today. There were three themes that received the most attention:
1) Liquidity
This was by far the most common topic of focus by my peers. The market collapse of 2007-2009 slammed the hedge fund industry when it came to liquidity. Over and over again I heard stories of hedge fund managers who performed well during the collapse but saw a significant percentage of assets redeemed. Why would this happen if they managed to lose only a small amount or actually make money? Simple ... liquidity! Many institutional and individual investors had money invested, on a leveraged basis, in hedge fund strategies that became illiquid as the markets collapsed. Investors had no choice but to pay back the banks with their more liquid investments, even if those investments were performing well. Margin is a double-edged sword but that is different topic.
FACT: A typical hedge fund wants you to tie your money up for at least six months to a year and charge you a 2% management fee and a 20% incentive/performance fee. This is not very liquid and it's expensive! Investors better receive a much higher return for accepting those two conditions. If they don't, then they should redeem ASAP and invest in some more liquid alternatives.
Six years ago I knew of about ten to 15 mutual funds that were managing their assets using typical hedge strategies and I thought only about half of those were worthwhile options for my clients. Today, it's a completely different story. Our firm tracks hundreds of different ETF, mutual fund and structured products strategies that provide hedge fund strategies. One feature that makes them so attractive is that they all have near daily liquidity and some have even produced significant alpha. My firm isn't alone. Many advisors and family offices are now investing with hedge fund managers in a managed account format versus the more traditional limited partnership structure.
2) Hedge Fund Replication Strategies
Hedge fund replication attempts to mimic the betas and returns of either individual hedge fund strategies or the entire hedge fund industry, using common and liquid exchange traded assets, such as futures, forwards, swaps and even ETFs. In using these investments to replicate returns, the goal is to not only replicate betas and returns, but to do so with comparable or less risk, and of course, less cost than traditional hedge funds. Moreover, because the investments used in hedge fund replication are liquid, the strategy itself is liquid.
Hedge fund replication has been an active area of research for many years in academia and the industry. Andrew Lo of MIT, one of the pioneers in the alternative space, wrote in an article published in 2008 that "hedge fund beta replication is neither better nor worse than direct investments in hedge funds-it is simply different because replication strategies trade off the full return of hedge funds for improved transparency, liquidity, capacity and fees."
Investors are becoming increasingly attracted to the idea of hedge fund replication as a strategy as they benefit from lower cost access to hedge funds by avoiding layered fees. Hedge fund replication is primarily available in ETFs, ETNs, mutual funds and separate accounts.
3) Transparency And Control
Bernie Madoff-does the name ring a bell? Madoff's fraud scandal is probably the most renowned in modern history. A court-appointed trustee has estimated losses for investors to be around $18 billion. How does someone get away with fraud of such a staggering magnitude for nearly two decades? Lack of transparency. Madoff refused to divulge certain types of information, claiming he had a special way of trading the accounts that nobody else could know about. Madoff's actions have made investors rightfully cautious of "secret" strategies and lack of transparency. I do not believe investors should compromise on the principle of full transparency.
The best way for investors to achieve transparency is to have their investments managed in a separate account structure. This allows investors to see everything in the account in real time. Another good option is to invest with hedge fund managers in a mutual fund structure. This provides an excellent way for the mutual fund administrator to always be aware of trades while monthly to quarterly positions are generally available to investors. If a manager can only be accessed through a limited partnership structure, then it's good to make sure they provide regular (monthly/quarterly) position details. Many hedge fund managers are providing these updates now because they know they will severely limit their ability to raise capital if transparency is lacking.
Three of the top trends of more liquidity, more hedge fund replication options and transparency in the alternative investment space appear to be here to stay for the long term. Morningstar's statistics tell us that each and every year a greater number of alternative investment mutual funds are being launched and many investors are utilizing these strategies. We also see more choices among ETFs and ETNs, and more managers are willing to provide separately managed accounts. My firm loves the way this trend has unfolded because we now have many more low cost, liquid, and transparent options available when constructing portfolios for our clients.