Unlike institutional investors, most financial advisors have steered clear of alternative asset classes. But as the markets continue a fitful pace, more and more advisors are seeking alternative assets to protect their clients' portfolios from ill-performing equities. A new report by Undiscovered Managers in Dallas, "Alternative Investments and the Semi-Affluent Investor," is designed to act as a first step in helping advisors perform an extensive due diligence process on alternative assets. "You have to do your homework," says Mark Hurley, Undiscovered Managers' CEO. The report, which is available for free at www.undiscoveredmanagers.com, offers advisors a broad overview of absolute return vehicles like hedge funds and managed futures; private equity, which includes venture capital, mezzanine financing, and leveraged buyouts (LBOs); and real estate, both private and REITs. The report describes the legal, operational, suitability, and tax issues surrounding alternative assets. "There is immense interest by advisors in alternative investment products. There's also immense apprehension," Hurley says. "We are at the front end of the cycle where [advisors] are going to get much further up the curve and develop their own dogma as to how these assets should be used. And then they will apply the dogma individually to clients." New York Bureau Chief Melanie Waddell sat down recently with Hurley and Undiscovered Managers' President Bob Worthington at IA's New York office to discuss the report and alternative investments in general.
What's the overall message that advisors should take away from the report? Hurley: A common trait of successful financial advisory firms of the future is that they are going to use these alternative assets in client portfolios. However, the only people who are going to be able to use them are those who do their homework because this is an area that offers immense opportunity, but it's fraught with danger. In many ways, alternative investments will be a key distinguishing factor between firms. But advisors will either distinguish themselves by being good at what they do with them, or by being very bad. In either case, they are going to get noticed.
So are you suggesting that to be competitive, advisors should develop a niche in alternative assets? Hurley: I'm not suggesting that they develop a niche for this. I am suggesting that these alternative assets will become, in the institutional world, just a matter of course and part of [clients'] portfolios. Institutional investors think these are natural investments that should be included as part of a portfolio. Advisors are starting to think about alternative assets [because they want to know], 'How do you get products that are able to enhance returns?' And more importantly, the traditional methods of lowering the systematic risk of a portfolio, namely diversifying across long-only strategies, has a lot less benefit than it used to simply because the long-only strategies are starting to correlate with each other.
Will advisors have a hard time capturing and retaining affluent clients if they don't use alternative assets? Hurley: Advisors who don't will be at a competitive disadvantage because investment performance, while it can't really help you, it can really hurt you. This is why we think portfolio diversifier-type products will be quite popular, especially if we go through a period of prolonged low returns on equities. A lot of market experts and institutional investors have decided that a core part of any allocation will include strategies that generate returns from things unrelated to the directional moves of the market. It's very easy for advisors to charge 1% to clients when you have 14%, 16%, 18% returns a year in the long-only markets. It's fundamentally different to charge 1% to somebody when net of fees they are getting 4%.
You've said that funds of funds are going to be popular with advisors. Why? Worthington: Most advisors, we believe, will go the fund of funds route, whether it's funds of funds for absolute return strategies or hedge funds or funds of funds through private equity. The fund of funds not only brings diversification among different strategies, but in essence you are hiring the experts who understand the business, who have relationships in the business and therefore can provide you with access to the best managers.
Hurley: A lot of this [due diligence] gets down to evaluating the fund of funds managers. We spoke in the paper about this as the "Wild, Wild West." Just as the hedge funds, absolute returns, and private equity businesses are unregulated, so is the fund of funds business. One of the key determining factors in selecting a fund of funds manager, other than making sure they don't do anything horrid, is accessing the best manager.
How do advisors find a manager? Hurley: The first step is not to go find one. The first step is to do your homework. Then you have to figure out what role you want your firm to play. Do you want to do some stuff in-house? Or do you want to subcontract it out? How will you use these [assets] within the firm? And you have to look at this on a client-by-client basis; what's suitable for one client may be inappropriate for another.
Let's talk about 1940 Act funds, which are becoming popular now. What's new about them? Worthington: Absolute return strategies or alternative investment strategies and their use in 1940 Act vehicles are very, very new. It has just been in the last year or so that people have tried to use 1940 Act vehicles for alternative investments.
Hurley: There are three different sets of rules that govern aggregation vehicles. One is the 1933 Act, which determines if it's going to be a public security or privately placed. Every 1940 Act fund is either public or private. If it's a public vehicle, it's registered under the laws of the 1933 Act. A separate part of the SEC handles the 1933 Act. Another group of the SEC handles the 1940 Act, which is the aggregation rules, which determines how many investors per vehicle. If you register under the '40 Act, you can take an unlimited amount of investors, but you have to have an independent trustee board and you fall under a set of rules and that's what a mutual fund is. The third issue doesn't involve the SEC, it involves the IRS, and it's Subchapter M of the Internal Revenue Code. Here you can select to be a mutual fund for aggregation purposes, it can even be public or private, which still could also be a partnership for tax purposes or it could be regulated as an investment company, depending on the tax election the vehicle makes.
What about the tax issues? For instance, when would you use a 1099 tax filing versus a K-1 filing? Hurley: Traditional, long-only mutual funds almost always select to be regulated as an investment company. The issue that comes up with these fund of funds vehicles that are created in the market--and again, it's still early on and it's not clear who's going to start a fund of funds vehicle--is this: Will they elect to be regulated as registered investment companies for tax purposes or will they elect to be partnerships? We believe they will probably be registered investment companies. And the reason is that these types of investment companies tend to be ferociously tax inefficient, with high levels of short-term capital gains and income. So ideally, the type of money that would be invested (this is the absolute return as opposed to private equity) would be money that is tax deferred. And if you invest tax-exempt money into a vehicle that is in partnership, and the partnership involves anything that's leveraged like convertible arbitrage or risk arbitrage, you instantly have the problem of unrelated business taxable income (UBTI): effectively tax-exempt money becomes taxable.
On the other hand, with private equity partnerships you have very long-term investments. You put the money to work and five years later you get money, so they are very tax efficient. Also, if you elect to be regulated as an investment company for tax purposes, [a private equity fund] has a series of diversification tests that you have to meet that are not simple. If you are going to meet these diversity tests, it's almost impossible in a private equity fund because you are making 10 investments over a long period of time. If you are making investments in a hedge fund of funds vehicle or absolute return, which includes managed futures, you can invest across 15 managers who in turn invest in thousands of different things. So it's easier to meet the diversification test if you make the tax selection as an investment company. It is very difficult to meet the diversification test if it's a private equity type investment. The way we think it will ultimately come out is that fund of funds vehicles for absolute return products will get a 1099, just like a regular mutual fund. For private equity ones, which are much longer-tailed investments, they will get a K-1.
What happened to the fund of funds Undiscovered Managers was putting together? Hurley: We are still trying to figure out how to do this in a way that makes sense. We also recognize the range of knowledge and understanding across the advisor community about alternative assets is not homogenous. What you have is varying degrees of experience and due diligence. So what you will wind up seeing is pockets where advisory businesses will enter this business. But it will be a while before the entire industry's comfortable with these types of asset classes.
What happens when the market turns around? Will people lose interest in these alternative assets? Hurley: When is this turnaround coming? Call me when it is.
Worthington: As advisors and clients become more educated about the benefits of these strategies, even when the market comes back, whether it's next month or seven years from now, they will still use alternative investments, or look to use them, because the benefits, if done correctly, are undeniable.