The new gold standard

Chalk up another hard-earned lesson from the financial crisis: Investors in limited partnerships, the structure of choice for most alternative investments, discovered that giving up liquidity in exchange for higher returns wasn’t such a good idea after all.

When stock values plunged and most asset classes followed, investors in limited partnerships were unable to pull out of their investments and recoup what was left of their principal. As a result, financial advisers are shifting more of their alternative-investment allocations to mutual funds, which offer investors more liquidity.

Investors now suffer an “aversion” to the limited-partnership structure because of liquidity lockups and redemption problems, especially in the absolute-return arena, said Scott Welch, senior managing director of investment research and strategy at Fortigent LLC. The firm is a consultant to institutional clients who collectively manage about $40 billion.

And after the fraud perpetrated by Bernard Madoff, “people got totally spooked of the LP structure” through which alternative managers have historically operated, Mr. Welch said.

Hedge fund managers, too, saw the disadvantages of partnerships when investors abandoned them in favor of more-liquid investments.

As a result, some proven hedge managers are now willing to work for a flat management fee under a mutual fund, observers said.

Morningstar Inc. counts 216 funds that use some type of alternative strategy, a number that is expected to grow.
Observers said that mutual funds aren’t appropriate for illiquid assets such as private equity or some distressed debt, but funds are now preferred for liquid investments, including long-short strategies with equities, bonds and currencies; merger arbitrage and global macro strategies using liquid securities; and managed futures.

Management talent will be increasingly important for these funds, as the track record of alternative types of mutual funds isn’t great.

Among the various types of alternative mutual funds, only precious-metals funds provided positive returns over the past three years as equities collapsed, according to Morningstar.

At the same time, endowment funds, which use heavy doses of alternatives, suffered major losses in 2008 and last year as investments in real assets suffered. Their illiquid holdings also became impossible to value, raising even more questions about their true performance.

“A lot of hedge funds proved not to be that worthy — even some we had — prior to 2008 when it was easy to make money,” said Michael Amash, senior vice president at Westmount Asset Management Inc., which has $1.1 billion under management.

“So if you tie up money, give away liquidity and transparency, there better be a rationale for that,” Mr. Amash said.

Prior to 2008, fund flows into alternative mutual funds averaged about $3 billion a year, said Tarek Helal, vice president of product development and research for alternative investments at Raymond James Financial Inc.

Last year, net flows were about $14 billion, he said. Through July of this year, flows totaled $13 billion, with $19.5 billion coming in over the trailing 12 months, Mr. Helal said.

NEW AND EXPERIENCED

Observers expect to see more rollouts of mutual fund products with experienced managers.

“I’m convinced we can get good managers in a “40 Act fund now,” said Jon Sundt, co-portfolio manager of Altegris Advisors LLC and president of Altegris Investments Inc., which runs $2.5 billion in alternative strategies for advisers. He was referring to the Investment Company Act of 1940, which regulates mutual funds.

“The credit crisis made it easier” for hedge managers to change their tune, Mr. Sundt said. “Investors pulled money from hedge funds, and managers saw that wasn’t good — they lost assets” because the funds were illiquid.

“High-quality managers, prior to 2008, never would have considered” working within a mutual fund, Mr. Welch said.

Traditional hedge managers will take pay cuts by working for a flat management fee, Mr. Sundt said. “A large, stable base of retail investors [in a fund] is more attractive to them” than skittish investors in a partnership, he said.

Altegris this month rolled out the Altegris Managed Futures Strategy Fund (MFTAX), which accesses some of the most favored commodities-trading advisers the firm uses in its private offerings, Mr. Sundt said.

In the past, a lot of mutual funds were launched, “but they had less than the best-of-breed managers,” Mr. Sundt said.

Of course, advisers still need to be cautious.

Alternative strategies tend to be complicated and expensive. Plus, manager track records tend to be shorter than in the traditional limited-partnership universe.

They require “more than your typical amount of research because of the complexity and novelty of the investments,” Mr. Helal said.

And fads are common, as with any other investment style.

“Mutual funds are very good marketing organizations, so if something works, more products will follow,” Mr. Helal said.

Having a name such as “absolute return” may help sell a fund, but it doesn’t mean that the fund will always produce positive returns, observers said.

For one thing, beware of long-short managers who don’t have experience on the short side, Mr. Welch said.

And funds that go short may not do it consistently or use large-enough positions to offer much downside protection.

E-mail Dan Jamieson at [email protected].