Risk-minded investors shift focus to alternative funds

Investors and financial advisers may be elated that the S&P 500 has almost doubled since it bottomed in March 2009, but that improvement hasn’t erased the memories of 2008.

The 1,600 advisers at the annual Investment Management Consultants Association conference last week clearly were more interested in ways to reduce risks to their clients’ portfolios than finding them returns.

“It may not have been on purpose, but the theme of this conference turned out to be the mitigation of portfolio risk,” said Frank Campanale, vice chairman of First Allied Securities Inc., who attended the conference in Las Vegas. He oversees wealth management products for the independent broker-dealer’s private client group.

“My clients are saying, “I have this money, Frank; don’t lose it for me,’” Mr. Campanale said.

Like many advisers, he is looking to a broader range of alternative assets to make sure that doesn’t happen. Whether it is hedge fund strategies, real estate, commodities, private-equity investments, timberland or scores of other investments, advisers are looking farther afield for assets whose returns are uncorrelated with the stocks and bonds that make up their traditional portfolio allocations.

“The value proposition of alternative investing is that it gives you diverse sources of return,” Jerome Abernathy, managing director of alternative investments for Security Global Investors, said during his session on alternative investing at the conference. “As you expand your sources of return, you expand the number of market conditions in which a portfolio can profit.”

Although investors are demanding more effective diversification in their portfolios, their direct investments in alternative assets have decreased since the financial crisis, said Tom Orecchio, a wealth adviser with Modera Wealth Management LLC.

Between Bernard Madoff and the hedge fund blowups, many high-net-worth investors have shied away from locking up their cash in illiquid and unregulated investments.

“The level of interest in alternatives is way up, but it’s not translating into the same demand for illiquid formats,” said Mr. Orecchio, whose firm manages just over $1 billion.

However, investors are flocking to new publicly traded mutual and exchange-traded funds that replicate hedge-fund and commodity-trading strategies with the benefit of active trading markets. ETFs now offer exposure to virtually any investing strategy or asset class imaginable.

According to data from Cerulli Associates Inc., 65 alternative-strategy mutual funds were launched last year, compared with 45 in 2009. Money flows into the funds were up 60% in 2010, and the funds now oversee more than $200 billion in assets.

Even the wealthiest individuals, who can invest directly with the best managers in alternatives, see advantages in publicly traded funds, where their money won’t have to be locked up for long periods.

“In more liquid asset classes, the investment is more easily reversible if the client changes their mind about it,” said Kyle Schaffer, a managing director in charge of manager research at Ballentine Partners LLC. The average client at Ballentine has investible assets of $50 million. Indeed, with his investors’ increased emphasis on liquidity, Mr. Schaffer’s now looking for significantly higher returns from illiquid private deals.

TAX-FRIENDLY

Mr. Schaffer allocates money to both private and publicly traded alternative assets. He said a tax-friendly direct investment in timberland with a projected return of 6% to 9% with low correlation to other assets got a “ho-hum” reaction from investors when he first proposed it in 2006. They now think it sounds great. “The asset class hasn’t changed but the environment has,” he said. He also has investments in publicly traded vehicles — two of his current favorites being the Natixis Alpha Simplex Global Alternatives fund (GAFAX), which attempts to replicate the hedge fund universe benchmark, and the Highbridge Dynamic Commodities Strategy Fund (HDCSX), which was closed to new clients on May 2.

Chris Battifarano, a portfolio strategist for GenSpring Family Offices LLC, has been making large allocations to alternative assets for years.

“Historically, we’ve had about one-third of our clients’ assets in alternative investments,” he said. “Today it’s about 40%, though it varies depending on the client. We’re building all-weather portfolios, the purpose being to reduce the correlations of assets in the portfolio and introduce strategies with different risk drivers to their success.”

LIQUIDITY’S DOWNSIDE

Mr. Battifarano has reservations about whether alternative strategies can be implemented effectively in a publicly traded vehicle. “The question is: Will they have to change their investing styles to work in the daily liquidity environment and will it have a knock on their performance? Just because an ETF is more liquid, it doesn’t mean it’s the right way to buy trees,” he said.

Ricardo Cortez, a senior portfolio specialist at Broadmark Asset Management LLC, agreed. “There will always be an alternatives bucket that can’t be replicated in a mutual fund vehicle,” he said. “Some strategies will remain appropriate only for institutions and high-net-worth investors who have the wherewithal to invest for 10 years.”

Investments in timberland or venture capital, for example, require patience and a long-term commitment that may not work in a fund that offers immediate liquidity for investors. Others, such as arbitrage strategies using high leverage to capture small profit opportunities, probably can’t work in an Investment Company Act of 1940 vehicle, where leverage is limited to 30% of assets.

Indeed, many of the alternative strategies now being offered in 1940 Act-compliant products, such as mutual funds and ETFs, have yet to be tested in truly tough market conditions. “We need a full market cycle to look at how these products will behave,” said Mr. Cortez, whose firm launched two long/short equity strategy mutual funds in 2009. His Forward Tactical Growth Fund Ticker:(FTAGX) has about $900 million in assets.

Nevertheless, Mr. Cortez, who also gave a presentation at the IMCA conference, believes that liquid, transparent vehicles offering alternative strategies will continue to grow in popularity with both retail and institutional investors. “If you’re a fiduciary of a fund, you can be sued if something bad happens with a private investment,” he said. “Registered, liquid products have advantages over nonregistered illiquid ones, even if they give up some performance.”

Whether public or private, alternative investments are likely to become a bigger part of an adviser’s asset allocation decisions, given the volatile post-financial crisis environment. “In these markets, clients have asked us to be more tactical and we need to respond to these requests,” Mr. Cortez said.

E-mail Andrew Osterland at [email protected].

Related Topics: Alternative Investments Conference