The allure of alternative investments -- potential gains that are uncorrelated with stock and bond price movements -- is not without risks that investors need to be aware of, a panel of experts told advisors during a breakout session at the 6th Annual Inside Alternatives Conference in Denver.

The event, sponsored by Financial Advisor and Private Wealth magazines July 13-14, drew over 600 financial industry professionals.

Risk characteristics, rather than “style box” labels, are a first consideration when evaluating alternative vehicles, said Jeffrey Davis, chief investment officer for Boston-based registered investment advisory firm LMCG Investments. Important risk parameters include correlation to traditional asset classes, how leverage is employed and managed, whether the strategy makes directional bets or tries to time the market, and whether the strategy uses multiple sources of alpha.

“It’s easier to see in liquid alts what the risk nature is because of the transparency that’s required by becoming a mutual fund vs. a hedge fund. It’s much safer for first-time alts investors to be in liquid funds,” Davis said.

But advisors should watch for ephemeral liquidity—another significant risk. “Things that are liquid can suddenly not be liquid. You have to be very careful,” he added.

Davis, who manages the LMCG Global Multi-Cap Fund, said global market-neutral strategies could provide diversification through low to near-zero correlations with other asset classes. They’re also a good way to insure against market declines, he said. “Once you strip out beta, all you have is alpha.”

Because alts often use leverage to amplify portfolio returns, Davis said, advisors need a solid appreciation of fat-tail risk. He recommended the landmark article, “What Happened to the Quants in August 2007?” by Amir Khandani and Andrew Lo, which discusses how several previously profitable quantitative long/short equity hedge funds suffered unprecedented losses.

Davis also suggested avoiding directional bets (such as global macro, managed futures and long-biased long/short strategies), shunning market timing and diversifying sources of alpha across multiple asset classes to create performance consistency. “Alpha diversification tends to smooth out returns,” he said.

Jeffrey Sarti, co-president of Morton Capital, a Calabasas, Calif.-based RIA firm, told the audience that he looks for smaller and niche investment opportunities in real estate to create true diversification and cash flow “in this stupidly low interest rate environment.”

Sarti said he tends to concentrate on funds with $50 million to $150 million in assets. The advantages of this focus are more targeted opportunities and less competition. The disadvantages are increased operational and business risks that are inherent in investing with smaller organizations. “We have to ensure that these smaller funds have appropriate levels of oversight,” he said.

Sarti said advisors should perform operational due diligence and watch for structural issues, including:

● Liquidity mismatches between fund terms and underlying assets, especially in downside scenarios.
● Fee structures that fail to align manager and investor interests.
● Inadequate operational controls, both internal and external, such as lack of third-party oversight on large cash wire transfers.

Sarti was particularly blunt about fee structures, citing excessive real estate acquisition and disposition fees that can incentivize managers to churn portfolios at the expense of potential long-term returns. He also warned of waterfall structures with outsized fees in upside scenarios. “Are you incentivizing general partners to go for home runs by taking on extra leverage?,” he asked the audience.

Other red flags include inappropriate preferred return structures and general partners with little or no skin in the game. “It’s important for the general partner to have a lot of money invested side by side with you,” said Sarti. For some fund managers, a 10 percent stake might not be enough. “They have to feel pain in a nasty environment. People make a lot of money in this space. They come and go. When things turn bad, they have to ride it out and fix the problems.”

Sarti also suggested that advisors tailor their due diligence based on the asset class and experience with the fund manager. For example in real estate, “With newer relationships, we’ll typically visit the property. We’ll always look at leverage and look to stress test the manager’s projections,” he said.

After the buy decision, an advisor’s work is just beginning, said Jeff Whitmoyer, head of fixed-income, asset allocation and alternative investments at Wells Fargo Fund Management Group. “Everybody’s familiar with the pitfalls of manager selection—making sure you hire the right people to manage the portfolios—but once you build a portfolio, the job isn’t over. The problem becomes ongoing monitoring,” Whitmoyer said. Management teams can be impacted by additions and deletions of personnel, while funds can be affected by changes in economies and markets.  

Wells Fargo runs scenario analyses of how its funds could be affected over time and through various past events, such as the 9/11 attack on the U.S. in 2001, the Asian financial crisis in 1997 and 1998, and the emerging markets rally from January to May 1999. A future risk the firm is modeling is a potential rise in interest rates.

Access to portfolio managers is also key to risk reduction. “There’s no way we would ever buy an investment product where we didn’t have access to the portfolio managers, not just in the presale, but a commitment from the shop on an ongoing basis that we can have access to the pullers of the triggers,” Whitmoyer said.

The relative importance of access to managers may depend on the liquidity of the investment, said panel moderator Brian Haskin, founder and chief executive officer of Los Angeles-based RIA firm Alternative Strategy Partners. If you’re investing in an illiquid asset that’s tied up for a number of years, you’ll likely want direct contact with fund managers, Haskin said. “If you’re investing in something where you can liquidate your investment tomorrow, it may be a little less worrisome.”