ALTERNATIVE INVESTMENTS: Alt-investment due diligence entails heavy lifting

DETROIT — Investing client assets in alternative products and strategies can expose financial advisers to a whole new set of challenges for due diligence.
While some alternative investments, such as hedge funds, will introduce risks associated with a less regulated marketplace, other products that fall under more stringent regulatory scrutiny can also introduce potential pitfalls due to their unique structures and investing strategies, according to industry sources.
Some examples in the mutual fund area are Rydex Managed Futures Strategy (RYMFX), Rydex Absolute Return Strategy (RYMSX), Merger Fund (MERFX), Hussman Strategic Growth Fund (HSGFX) and ICON Long/Short Fund (IOLIX).
“The due diligence process should consist of both quantitative and qualitative research,” said Hossein Kazemi, academic liaison for the Chartered Alternative Investment Analyst Association in Amherst, Mass.
Mr. Kazemi, who is a professor of finance at the University of Massachusetts Amherst, explained that beyond calculating performance and measuring fees, the due diligence process should also include face-to-face meetings with investment managers, as well as thorough personal and professional background checks. Establishing a certain level of comfort with investment managers is a primary concern for J. Patrick Collins Jr., principal of Greenspring Wealth Management Inc. in Towson, Md.
“First and foremost, when we’re looking at an alternative investment, we need to feel comfortable about working with the people at the management firm,” he said. “Ideally, we’d want to be referred to an alternative investment by somebody we know and trust.”
Mr. Collins, whose firm oversees $40 million in client assets, is allocating assets into pools of real estate, energy, infrastructure and mortgages. “My biggest concern is being burned, which is why we focus on the people managing the assets,” he added. “Before we invest in anything, we always spend about three to six months studying it.”
Getting beyond stocks, bonds and plain-vanilla mutual funds requires a new set of rules for most advisers, and many of them rely on patience and meticulous attention to detail when it comes to some of the more esoteric products.
“The first thing you always do is discount any back-tested data that’s being presented,” said Derek Imes, president of Principia Investment Advisors LLC in Bogart, Ga.
“It takes a little more time, but I want to identify the people and find out what they’re actually doing,” he added. “I’ll go and meet with the managers and speak to their accountants and the people they’re doing business with.” Mr. Imes, who allocates between 15% and 20% of his $85 million in client assets to alternative strategies, likes some of the registered hedge fund products coming to market.
However, having worked with alternatives for more than eight years, he has learned that it sometimes helps to be creative.
When the Terrapin Beer Co. in Athens, Ga., was recently looking for capital to help the microbrewery expand beyond the Southeast region, Mr. Imes pooled $800,000 from six of his clients inside a separate limited liability company to take a 30% ownership stake in the brewery.
The higher fees associated with alternative strategies can be an initial turnoff for some advisers.
Beware of hidden fees
While some in the alternatives arena will make the case for paying attention to returns after fees are deducted, savvy advisers warn potential investors to dig deep into the paperwork and look out for hidden fees. “Most people will look at the returns net of fees, but you still need to think about how those fees will look during a negative year,” said Nicholas Rowe, president of Focus Capital Wealth Management Inc. in Bedford, N.H.
Mr. Rowe, who manages $75 million in client assets, said that in addition to justifying the fees to his clients, he wants to be able to justify an investment to the Securities and Exchange Commission.
“You have to watch out for those layered fees, because some of those guys don’t do a good job of disclosing everything,” he said. “And if you’re acting as a fiduciary, you better be doing what’s in the best interest of your clients, and you have to be able to justify all those allocations to the SEC.”
Because many alternative strategies are less liquid, advisers should approach such investment allocations as they would a long-term business partnership, according to Jamie Biddle, chairman and chief executive of Verdis Investment Management LLC in West Conshohocken, Pa.
“When it comes to alternative investing, the requirements are often quite complicated because they’re not transparent, and there are lockup periods, which means you really need to understand who you’re working with,” he said.
Verdis, which works primarily with endowments and foundations, has $400 million under management.
Because many alternatives, such as hedge funds, are catering to the big-money institutional investors, Mr. Biddle recommends that advisers focus on funds of hedge funds, which offer more diversification and lower investment minimums.
“Whenever you start thinking about alternatives, your due diligence should be exhaustive and extensive,” he said. “Beyond just the construction of the portfolio, you need to understand the manager’s background, you need to know who his business partners are and what prime brokers he’s working with.”
Mr. Biddle, who said advisers and individual investors tend to follow the lead of institutional investors, said the appetite among advisers should continue to grow.
“I would argue that there should be more demand for alternatives among advisers,” he said.