This past August, Morningstar and Research magazine surveyed financial advisors on the state of alternative investments. The perspective of and choices made by financial advisors, their clients and prospects are perceptibly shifting and it's certainly important enough for advisor professionals, investment research firms like Morningstar, and industry publications like Research to confirm by how much.
In order to do so, we distributed an Internet-based survey to some 70,000 financial advisors nationwide. A statistically significant 600 advisors responded, with the most typical profile being a wirehouse or independent broker/dealer advisor, RIA or financial planner based in the Northeast, Midwest, or West with fewer than 100 clients, under $500,000 in gross production or income and under $100 million in assets under management. Most advisors responding to the survey also held either the Series 7 or Series 63 license and their compensation was predominantly (60 percent) fee-based.
In order to have a common point of reference, the survey defines alternative investments as:
o Hedge funds
o Commodity funds -- including Commodity Trading Advisors ( CTAs) or managed futures
o Capital-protected and structured products
o Real estate
o Private equity/venture capital investments.
We asked the advisors to tell us their definition of alternative investments and most responses confirm we captured their perspective. One thought that grows stronger each year is nicely summed up by an advisor's comment that, "Nothing is alternative. This is '50s thinking that is way behind the times for people who are still stuck in the Strategic Asset Allocation time warp."
There were a few mentions of equipment leasing and limited partnerships. The most prevalent input, and a somewhat worrying one at that, is that 18 percent of advisors stated that publicly listed REITs were in their definition of alternative investments. Why worrying? A convincing body of research has found that REIT stocks and real estate exposure are not one and the same; the former is certainly not a proxy for direct real estate property investments.
In overview, two-thirds of advisors nationwide currently have more than 10 percent of their clientele using alternatives, with 28 percent of those advisors indicating that more than half of their clients have made the transition to include alternative investments in their portfolios. However, at the present time, most client portfolios typically have less than 10 percent of their assets allocated to alternatives. From a combined perspective, it would seem that there is still a lot of room for growth by alternatives, driven by increased adoption and higher usage rates.
On this point of future potential for growth, the advisors also agreed, with 65 percent indicating that they expect more than double-digit growth in alternative assets under management in their respective practices (See Exhibit 1). Of those, 40 percent expect the growth in alternative AUM to range between 11 percent to 20 percent every year over the next five years and 25 percent expect their practice to see growth exceeding 20 percent every year for the next five years.
The larger advisory practices, with more AUM, are behind the general forecasts of accelerated growth rates. For example, the largest set of advisors expecting growth rates of 11 percent to 20 percent are in practices with $100 million to $500 million in AUM, and 30 percent of advisors in businesses with more than $500 million in AUM expect their alternative business to grow between 21 percent and 30 percent annually until 2011.
The 65 percent of advisors anticipating double-digit growth is a noticeable and significant pick-up in both the number of advisors and the growth rate that most advisors have experienced every year over the past five years, where 57 percent of advisors reported more than double-digit annual growth in alternative AUM (See Exhibit 2).
The growth expectations are impressive, but to get a clearer idea of how important advisors think alternatives are, we asked them to tell us the extent to which they thought alternative investments will become as important as traditional investments (which we defined as stocks, bonds and mutual funds). Most -- 34 percent -- think alternatives will become "somewhat" less important over the next five years and a further 18 percent believe "much less important," a normal expectation perhaps of deceleration in a high-growth area. Still, that as many as 48 percent of advisors see alternative products taking on greater importance probably indicates a strong basis to believe they fill an important unmet need for their clients.
Until now, real estate and commodities have been the alternative investments making the most inroads for investors and their advisors (See Exhibit 3). Hedge funds and private equity/venture capital have taken secondary roles. Whether an advisor holds a Series 7 or 63 license or is a CFA or CFP, the pattern essentially holds.
Looking ahead, 28 percent of advisors anticipate that capital-protected/structured products offer advisors the greatest alternative business growth potential in the next five years, dislodging real estate from its main role in driving growth (See Exhibit 4). We surmise that demographics would be driving this trend, since the growing population of retirees would likely be attracted to these products. Hedge funds and private equity/venture capital usage is expected to remain relatively unchanged. That is, 19 percent of advisors anticipate hedge funds will drive growth over the next five years, compared to 17 percent who report hedge funds have driven growth until now.
A very interesting finding is that investment advisories of all sizes equally anticipate the strong growth in capital-protected and structured products. Even firms with less than $50 million in AUM expect these products to be the main drivers of their alternatives business. Only advisors at practices between $100 million to $500 million in AUM are expecting another product, namely hedge funds, to exceed capital-protected products in growth prospects by a small margin (27.1 percent vs. 26.5 percent). And, as the percentage of an advisor's compensation provided by asset-based fees increases (and commissions fall), these advisors expect to be using more hedge funds in the next five years than capital-protected products, but again by a small difference. For advisors obtaining all of their compensation from fees, 26 percent expect hedge funds to drive growth until 2011, but this is just slightly higher than the 23 percent expecting structured products to carry the day.
Equally, there is a good indication that advisors and their clients understand how alternatives fit and work in a portfolio context. An impressive 58 percent report that addressing portfolio correlation is the objective fueling growth. Driven to some degree by both hedging and speculation motivations, 49 percent of advisors indicate that absolute returns are behind the increase in alternatives. For 39 percent of advisors, alternatives are being applied to filling portfolio allocations, while 30 percent indicate that different investment techniques (such as shorting and leverage) are motivating themselves and clients.
The survey also confirms the factors that might restrain alternatives from reaching their full potential with advisors and their clients. It's not too surprising that 49 percent report lack of understanding is an inhibitor, closely followed by lack of liquidity at 48 percent (See Exhibit 5). With their continued high profile, more information is available and becoming available on alternatives. This in turn, it is reasonable to suggest, will help investors and their advisors to appreciate the time commitment required for alternatives to work and the measures available to indicate if fees are commensurate with alpha and improvements in portfolio efficiency. Increased usage lies at hand if money management firms, investment research firms like Morningstar, and advisors themselves work to close the knowledge gap for investors.
Advisor Views on Hedge Funds
On the specific and very pertinent topic of hedge fund regulation, two questions elicited especially thought-provoking results that should be of particular interest to Chairman Cox and the SEC.
In regards to the relevancy of the SEC's qualified-investor restriction, we estimate that approximately 44 percent of the responses indicate the restriction is very relevant. Our query, which asked for open-ended answers, elicited comments from advisors along these lines:
o "People with a lot of $$$ to invest are not necessarily 'sophisticated' (nor are all the advisors who select the vehicles into which they put clients' money)."
o "Very relevant for the illiquid and complicated products. Totally irrelevant for the mutual fund variety of alternatives."
A smaller but still substantial 33 percent of advisors indicated the qualified-investor restriction is not relevant today:
o "Irrelevant. Too many ways around restrictions."
o "Don't believe it makes sense setting somewhat arbitrary restrictions."
o "Qualified investor products force the client to pool their funds to one advisor. Great job! But some products are registered and principal-protected. Everyone should have access to these products."
A further 22 percent of the responses could be classified as being unsure about the relevancy of the investor restriction.
On a second question about hedge funds, one emphatic opinion shared by 70 percent of advisors is that hedge fund registration in the U.S., whether required or voluntary, is positive. Some of the insightful comments were as follows:
o "Should be mandatory with more required disclosure and due diligence than traditional mutual funds."
o "The cases of con men passing themselves off as hedge fund managers while perpetrating a Ponzi scheme makes this important."
o "Regulation at times can be overdone. However, I do think guidelines are warranted here. Investors should be able to see and know what is going on inside the funds."
o "Very positive, but I do have a concern that as registration, reporting and visibility increases too much capital will be attracted, which will reduce opportunities and the level of talent."
o "As long as they are not ordered to disclose their trade secrets and investment-strategy specifics, I don't see much real harm to them other than disclosing their egregious compensation."
Maybe advisors see registration as an important type of background check for hedge funds to gain further traction with them and their clients. Whatever the motivation, the endorsement of registration is strong and hopefully will make an impression on the hedge fund firms actively seeking assets from investors in the United States.
Overall, this inaugural survey provides genuine insight into the quickly evolving role of alternatives and a reassuring way to translate a great deal of anecdotal impressions into a quantitative gauge of what has and is happening in the investment marketplace. In short, what was considered alternative (real estate and hedge funds) has pretty much gone mainstream and a new definition of what encompasses alternative investments has emerged -- capital-protected and structured products and commodity funds and managed futures.
Steve Deutsch, CFA, is Director of Separate Accounts and Product Development Manager, Managed Investments Research, Morningstar.