From the April 2007 issue of Investment Advisor • Subscribe!

Behind the Curtain

Alternative investments provide some essential benefits for the HNW portfolio: Returns, diversification and risk management

RIAs and their high-net-worth clients have dramatically increased the use of alternative investments in their portfolios in recent years, and are on track to continue this trend. These investors are looking for better returns than they have received through traditional investments, as well as diversification and a host of other benefits alternatives can provide.

However, not all advisors, much less their clients, are comfortable with alternatives. Their concerns range from legitimate ones about risk to received wisdom about their supposedly inherent dangers.

But RIAs are increasing their use of alternative investments, particularly for the sophisticated high-net-worth client. Future articles will look at ways to access various alternative investments and the precautions necessary to protect investors.

To begin, let's assess the use of alternatives within the advisor community. A recent survey of RIAs by Rydex AdvisorBenchmarking, Inc. found that they have increased their use of alternative investments (hedge funds, private equity, real estate, commodities, currencies, and managed futures) over the past five years. According to Rydex, most advisors (42%) have moderately increased their use of alternatives (from zero to a 25% increase) in the past five years, while 24% increased their use of alternatives by more than 100%.

Advisors use alternatives, the survey found, to sample different investment techniques, to get absolute returns, to fill portfolio allocations, and to address portfolio correlation issues. A majority of respondents said they would increase their use of alternatives by up to 25% over the next five years; 13% said they would do so by more than 75%.

That's the RIA approach in aggregate, but what about individual advisory firms? New York-based Lenox Asset Management Group, for one, has experienced an increased demand by its clients for alternative investments. Michael Kuziw, a VP at Lenox, says that a big reason for this is education. His firm's high-net-worth clientele have seen their college endowments, pension plans, and the boards of private endowments on which they serve increase their exposure to alternatives, whetting their appetites while giving them comfort that they are making a good investment decision.

Kuziw and others point to Yale University's endowment as a leader among institutional investors in the move to alternative investments. According to Don DeWaay, principal of his own firm in West Des Moines, Iowa, Yale put just 20% of its portfolio in domestic marketable securities, and the remaining 80% in overseas or alternative investments. "They have access to these things and an understanding of them," he says.

So what are the advantages of using alternative investments in clients' portfolios? Ed Egilinsky, managing director of alternative investments at Rydex, points to three specific advantages. One is that alternatives, including REITs, hedge funds, and private equity, do not have a direct relationship to traditional investments. Managed futures, for example, have zero correlation to the overall market. Hedge funds may have some correlation, depending on the strategy a fund employs, but this still tends to be low. In addition, alternatives provide exposure to areas outside the long-only space, such as currencies. Finally, alternatives complement a traditional portfolio particularly in reducing the overall risk of that portfolio. Over time this benefit increases, as alternatives inherently have a low correlation to stocks and bonds.

DeWaay points out that institutions like Yale that use alternatives are very successful because they look at market inefficiencies. Alternatives, he says, represent the road less traveled, where one isn't competing against millions of others who are buying stocks in the most efficient market in the world, and for most of whom success is a matter of luck or swimming with the tide--until there's a downturn.

It is precisely the inefficiencies in everything from real estate to oil and gas and the specialized knowledge and experience these types of investments engender that make them attractive, DeWaay says. "You can go in and buy at very low cost; some are almost arbitrage situations, i.e., taking things out of an inefficient market and putting them into an efficient market--that's what private equity is all about."

In all cases, says DeWaay, the investor is trying to get close to people who have the integrity, the resources, the knowledge and experience, and the track record that suggest they really know what they're doing and have the right connections to get into spaces that provide a much higher degree of diversification in a portfolio than marketable securities do, and ultimately better fundamental valuation. "You're buying these things with a much higher profit potential."

This doesn't necessarily suggest higher risk; in fact, incorporating these types of investments in a portfolio can not only provide a chance to profit much more substantially, but also drop the aggregate risk. DeWaay says that when the markets went down substantially in 2000--2002, his firm, which uses a wide variety of alternatives, took off even as others suffered. Throughout the 1990s, he says, alternatives had been a hard sell.

Reducing Volatility

Chris Dardamon at Brightworth Private Wealth Counsel in Atlanta says alternative investments serve to build parts of a portfolio that aren't correlated with the beta market. The objective in the alternatives space, he says, is to create market-like returns with lower volatility that go up when the market goes down, providing some downside protection. A healthy allocation to nontraditional strategies is a "good all-weather piece of portfolio" that does well for investors--even in up markets. But during downdrifts, it provides great peace of mind.

Put another way: "I trust alternatives a lot more than I trust the stock market," says Gene Balliett, of Balliett Financial Services in Winter Park, Florida, who favors private equity. "The stock market is wildly emotional, and elements of it are rigged, like technical floor trading. I think a well-run private business is far more secure as an investment than money in the stock market--speaking in general terms."

Investors expect a hedge fund portfolio or a fund of hedge funds to provide absolute returns and protection on the downside, says Hilary Till, principal of a proprietary trading firm in the Chicago area. In contrast, investors expect a traditional portfolio, which contains a combination of different asset classes, to limit downside risk through diversification.

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Every hedge fund on a standalone basis needs to limit risk, she says. It does this by using strategies such as shorting or derivatives to create an asymmetric return profile, thereby limiting downside risk, while capturing the upside in the asset class's opportunity set.

An investor puts hedge funds in his portfolio to provide absolute returns, says Till. He wants a manager who protects his downside, through expertise in market timing, or use of disciplined stop-losses or shorting to get rid of systematic risk, or other tools, while allowing him to get returns that are still correlated to the asset class. Till points out that limiting downside can also affect the upside because tools to limit downside won't take full advantage of the upside. During the 2005 commodity boom, for example, a number of natural resources hedge funds didn't match the maximum result of the commodity indexes. A very diversified portfolio of hedge funds will mute upside, but provide downside protection, she says.

A fund-of-funds portfolio contains a wide variety of hedge funds in order to try to diversify the idiosyncratic business risk associated with each individual manager, says Till. That's important, because with each manager there may be only one or two key decision makers.

A very diversified portfolio of hedge funds will expose the investor to risk factors that aren't correlated to whether bonds or equities are going up or down. To get extra returns, for example, the portfolio may contain more illiquid instruments, exposing the investor to liquidity shocks, but typically as long as these aren't overly leveraged there's a return premium associated with that.

On commodities, Till says investors today are interested in two main results: diversification, of course, as well as "the call option" on Asian growth. "Assuming continued economic growth driven in part by the industrial revolution in China, what are the investments you expect to benefit from that macro theme?" she says. "Industrial-sensitive commodities are one of many choices."

Education and Publicity

DeWaay and others concede that a large segment of high-net-worth investors are uninformed about alternatives.

The same goes for RIAs. Mention hedge funds or managed futures, for instance, and many will recoil because of bad experiences they've had or, more likely, the headlines they've seen reporting spectacular blowups. Indeed, principals at major alternative investment firms have acknowledged that bad press has hurt their industries and urged their peers to step forward to counteract the negative publicity.

Jonathan Nelson, chief executive of Providence Equity, told a conference of private equity professionals in February that amid the publicity surrounding recent record-breaking buyouts and takeovers of well-known companies, some widely accepted myths about the buyout business have arisen that could end up hurting the industry. These include suggestions that private equity firms are star-driven boutiques, that private equity is easy, and that the private equity bubble is about to burst.

And John Maltby, a senior VP at DKR Capital, a hedge fund firm, told a conference last fall that news articles about the elaborate lifestyles of hedge fund managers, combined with headline-grabbing blowups and calls for regulation, were exacerbating an already negative image of the hedge fund industry. He called for steps to counter such publicity.

Rydex's Egilinsky is fully aware of the negative image and minimal understanding that surrounds alternative investments. He said his firm is trying to address the issue by publishing white papers and providing information to clients about the advantages of alternatives.

DeWaay says his firm has a specific process for handling client hesitation to try alternatives in the portfolio construction process. First it discerns the client's goals, return objectives, past experience, sophistication, and liquidity needs before making any change in their investment landscape. Next, diagnostics on the existing portfolio sort out what makes sense for the investor and what's not a good fit. The firm then determines how much liquidity the investor needs, and educates him on alternatives that would make sense in the portfolio. Then comes the first dip into the alternatives space. The client's assets are repositioned, mainly in marketable securities, with a smattering of alternatives.

Portfolios are a work in progress, says DeWaay. Depending on the size of a portfolio, it may take two to five years to get it into optimal shape. This is because opportunities may not be immediately available, especially with private equity.

He says the firm starts off with more benign alternative projects, which almost always include real estate, as well as collateralized lending, private note offerings, and the like if the client needs and wants income. It may even include some energy and private equity upfront, depending on what is available, and quite probably some hedge funds.

It takes many clients 18 to 24 months before they start "to get it," says DeWaay. Five years out, they enthusiastically embrace alternatives. To get to that point, he stresses, the firm has educated them through incremental exposure to alternative investments and making sure they have all the information they need to make good investment decisions. "A smart, informed client is a good client for us; a na??ve or timid client is not."

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