In the aftermath of the 2008 financial crisis, Ed Kohlhepp's clients are as interested in preserving their capital as they are in increasing it.
As markets become more unpredictable, Mr. Kohlhepp, president of Kohlhepp Investment Advisors Ltd., is using absolute-return funds to protect the value of portfolios.
“They're defensive,” Mr. Kohlhepp said. “We believe we're in a secular bear market that could continue for a number of years. As a result, it's more important to play defense than offense in this environment.”
EASY SELL
That approach is an easy sell to investors who are in or nearing retirement.
“We find our clients are still fearful of the markets,” Mr. Kohlhepp said.
Alternative investments such as absolute-return funds are an increasingly important strategy as global markets become more connected, according to Mr. Kohlhepp.
“We are looking at alternatives to balance out the portfolios so that everything doesn't go up and down at the same time,” he said.
They are a way to enhance returns and decrease volatility at a time when it's become less possible to find portions of the equity and bond markets around the world that are not correlated.
The continuing economic crisis in Europe is an example of the connectivity of the financial world. Worries on any given day about the stability of the eurozone can affect Asian and then European markets before U.S. exchanges open.
Once the bell rings on Wall Street, traders are poised to react to the developments that are rippling across the globe.
“If a pin drops in Europe, we hear it here, and vice versa,” Mr. Kohlhepp said. “Our news passes to them, theirs passes to us. That wasn't the case so much 15 years ago. Nothing operates in isolation anymore.”
The swirl of negative market activity in May provided an example of the risks that alternative investments can mitigate. Worries about European debt spiked, while political uncertainty in the United States was exacerbated by a weak jobs report.
RELATED: Learn more about retail alternative investments at the InvestmentNews 2012 Alternative Investments Summit
“The alternatives worked favorably in minimizing volatility — not eliminating, but minimizing,” Mr. Kohlhepp said.
He uses a variety of alternative investments, including structured notes, managed futures, oil and gas investments, real estate investment trusts and hedge funds. His favorite is absolute-return funds.
“Absolute return has a narrower band of volatility,” Mr. Kohlhepp said.
Some of the absolute-return funds that Mr. Kohlhepp uses employ arbitrage strategies, some track currency swings, others are run by contrarian portfolio managers.
PALTRY GAINS
The funds come with downsides. For one thing, they're probably not going to produce much in the way of gains — an increase of 1% to 2% annualized over five to 10 years might be the most to expect. They also are relatively new — they came onto the scene over the last decade — and can be complex.
Those factors make kicking the tires of a fund a priority.
“It is important for us to do due diligence on the firms we're working with,” Mr. Kohlhepp said. “The main risk is that there's no true definition [of absolute-return funds], and they're not well-understood by the public.”
When recommending absolute-return funds, there also is a premium on client communication.
“We try to spend time educating clients on what is meant by absolute return and our definition of absolute return,” said Mr. Kohlhepp, whose firm has about $125 million in assets under management.
Those discussions may focus on investors' moving out of absolute-return funds if they are tempted by a market that is on a strong — even if temporary — upswing.
FREQUENT REVIEWS
“In every client meeting, we review the risk profile to make sure they still want to play defense,” Mr. Kohlhepp said. “We ask a series of questions to make sure they want to [increase risk] for the right reasons rather than just feel better about the markets.”
In general, Mr. Kohlhepp said, clients who are close to retirement should have at least 20% of their portfolios in alternative investments — and perhaps as much as half. For middle-age investors, the benchmark is around 10%.
Across the age ranges, more education is required before alternatives are widely embraced, he said.
“The median investor has a tough time understanding ETFs, and ETFs have been around for years,” Mr. Kohlhepp said. “It will take a while for investors to understand alternatives — unless they are serious students of investing or have their own adviser.”
[email protected] Twitter: @markschoeff
