Investors seeking new choices

The pursuit of investment performance in an increasingly uncertain market is drawing more attention to alternative investment strategies, a situation that could place more pressure on financial advisers to step outside their traditional comfort zones.

“We’re definitely seeing the trend that people are taking a closer look at how they invest and that means a closer look at alternatives,” said Lori Klash Winkler, a spokeswoman for Rydex Investments of Rockville, Md.

According to a March survey conducted by Rydex of 500 mutual fund investors with at least $250,000 in investible assets, consumers are ready for alternatives, but most still need direction.

While some financial advisers are already well ahead of the curve in researching and allocating assets beyond plain vanilla stock and bond mutual funds, the Rydex research shows that investor appetite for alternatives might be testing the limits of what financial intermediaries are prepared to provide.

Nearly half of those investors surveyed said they would have been investing in alternatives as far back as 2002 if they had access to investments and strategies.

Seventy percent of those respondents seeking alternatives cited diversification as the leading driver.

This is the kind of growing investor appetite that could play right into the hands of firms like Cogo Wolf Asset Management LLC, a San Francisco-based fund-of-hedge-funds firm with $100 million under management.

“Investors right now are looking for balance, and they want true returns balanced with old-fashioned risk avoidance procedures,” said Christopher Wolf, a managing partner.

The Cogo Wolf portfolio, which has a $300,000 minimum and is only available to investors with at least $1 million in investible assets, is designed with the financial adviser in mind, he said.

“A lot of funds of funds have become high-leverage, low-volatility checking accounts,” Mr. Wolf said. “We’re not trying to be all things to all people, so we don’t use leverage at the funds-of-funds level and we avoid using hedge funds that are highly leveraged.”

Efforts by firms in the alternatives space to look beyond just the deep-pocketed institutional investors to some of the more sophisticated advisory firms has made the expansion into alternatives a little easier for firms such as Peak Financial Management Inc. in Waltham, Mass.

“I get the feeling some of the fund-of-funds firms are starting to look at smaller advisory firms and family offices as a growing market,” said Shana Orczyk, a research analyst for the firm, which oversees $500 million in client assets.

Ms. Orczyk, who was hired specifically to help Peak Financial increase its exposure to alternatives, spends most of her time researching and conducting due diligence on hedge funds and private-equity investments.

“As the alternatives industry has grown, there has been more interest among investors and more confusion,” she said. “There is growing demand for alternatives from clients and there is a growing need within their portfolios.”

According to Hedge Fund Research Inc. of Chicago, the hedge fund industry is estimated to comprise more than 10,000 individual funds and nearly $2 trillion in assets through the first quarter of 2008.

Year-to-date through the end of May, the most recent month for which performance data is available, the HFRI Weighted Composite Index was up 0.1%.

This compares to a 3.8% decline by the Standard & Poor’s 500 stock index over the same period.

The Lehman Brothers government/credit bond index gained 0.9% over the period.

The best performing hedge fund categories over the first five months of the year were macro, up 5.4%, and short bias, up 2.9%.

“To be flat over such a volatile period might be something that hedge fund investors can take some comfort in,” said Ken Heinz, president of HFR.

The volatility of the financial markets and the unraveling credit crisis have affected the overall size of the hedge fund industry. Fund launches have gone down while liquidations have gone up in 2008, according to Mr. Heinz.

The 247 hedge fund launches in the first quarter was the lowest quarterly total in eight years, compared with 251 hedge fund launches during the first quarter of 2007.

There were 170 hedge funds liquidated during the first quarter of 2008, compared with 138 in the same period last year, according to HFR.

The hedge fund industry is on pace for 987 launches in 2008, compared to 1,152 last year, and 679 liquidations, compared to 563 last year. 

USING ALTERNATIVES

As some advisory firms push deeper into more sophisticated strategies involving hedge funds, funds of hedge funds and private-equity investments, traditional money management firms are moving toward financial advisers with a range of products that offer alternative investment strategies.

“The early adopters have been on the bandwagon for a while and they recognize the athleticism that shorting and leverage can add to a portfolio,” said Dan O’Neill, chief investment officer of Direxion Funds, a Newton, Mass.-based firm with $1.6 billion under management.

Direxion Funds, like Rydex, which manages $15 billion, offers registered investment products that enable advisers to create and customize their own alternative strategies.

This is particularly useful for clients who might not meet the net-worth requirements associated with hedge fund investing.

“A lot of advisers look at products like ours and get it right away,” Mr. O’Neill said. “Then there’s the much larger group that looks at it and isn’t sure how to use it. That’s the group we’re trying to target now.”

Direxion has entered into a partnership with Wilshire Associates Inc. of Santa Monica, Calif., to build asset allocation models using some of the Direxion funds that offer shorting and leveraged exposure.

“With traditional mutual funds, you largely have to defer to the portfolio manager, but with our strategy you show up with an opinion on the market,” Mr. O’Neill said. “For those people looking at the markets right now and trying to be able to react, we’re showing them how you can use leverage and shorting inside an asset allocation model.”

For some advisers, the move into alternatives is not an option — it’s a matter of survival.

“I see a lot of brokers and advisers who don’t know what to do but they know that their models aren’t working anymore,” said Gary Clemmons, owner of Texas Capital Management in Baytown.

Mr. Clemmons, who oversees $50 million in client assets, started moving into alternative strategies in 2002 and now estimates that his client portfolios are 40% allocated to alternatives, such as commodities and various hedging strategies.

“It has worked out extremely well for us,” he said. “Right now we’re down less than 1% since the start of the year, and in this market I consider that a major feat.”

IGNORANCE ISN’T BLISS

Whether advisers are ready to appreciate it or not, alternative investment strategies are emerging as a distinguishing feature in the financial advice business, according to Patrick O’Connor, vice president of wealth solutions at Raymond James Financial Services Inc. of St. Petersburg, Fla.

“In the wealth management space, whether an adviser embraces hedge funds or not, they must be familiar with them,” he said. “Education is critical to make sure advisers are aware that alternatives are having an impact on the industry, and that they have an informed opinion.”

Mr. O’Connor makes a distinction between alternatives such as hedge funds and hedging strategies offered by firms like Rydex and Direxion. But he also acknowledges the trend toward a wider variety of products to meet a growing appetite for investment diversity.

“Over the last eight years, a lot more advisers have been looking at alternatives as a way to add returns to a portfolio,” Mr. O’Connor added.

When it comes to the use of alternatives, he divides the overall adviser universe into three broad categories: those who avoid alternatives completely, those who reluctantly respond to client requests or market pressures, and those who are fully on board.

Two major mistakes advisers make with regard to alternatives, Mr. O’Connor said, are ignoring the category and defining it too narrowly.

“Too often, financial advisers wrongly characterize all hedge funds using a single strategy subset such as long/short equity or global macro trading,” he said.

As the Rydex investor survey illustrated, the appeal will vary depending on factors such as age and net worth.

Nearly 30% of those under the age of 31 have turned to alternatives for performance, while 21% of those investors over the age of 62 rely on alternative strategies to help preserve capital.

“If you don’t keep up with what’s going on in the alternatives industry you’re doing a disservice to your clients,” Mr. Clemmons said.

E-mail Jeff Benjamin at [email protected].