November 3, 2009

A Case for Alternatives

Two words sum it up: diversification matters. Following severe down markets, investors and advisors alike should take inventory and assess what they could have done differently. Not that we are completely out of the woods, but you may have noticed that alternative investment strategies are gaining mainstream popularity. Diversification benefits continue to be the main attraction; however, a challenging investment outlook for traditional asset classes along with improving access to alternative strategies are now part of the conversation.

First, let's revisit the diversification benefits of alternative investments in light of the recent bear market. Short-term correlations between traditional asset classes (equities and fixed income), and alternative strategies, approached one--meaning basically no diversification behavior between the assets classes--in 2008, as losses were widespread. Still, over the last fifteen years (ending 8/31/09) the correlation of the Credit Suisse Tremont Hedge Fund Index, which includes multiple alternative strategies, is 0.55 relative to a balanced stock and bond portfolio consisting of a 60% allocation to the S&P 500 Index and a 40% allocation to the Barclays Aggregate Bond Index (formerly the Lehman Agg.). Clearly, this low degree of correlation is valuable over multiple market cycles as it helps dampen volatility, reduce risk and boost alpha. For instance, investors would have been able to increase alpha in the 60%/40% stock-bond blended portfolio over the trailing five-, ten-, and fifteen-year time periods if they had swapped 10% of their fixed-income allocation to alternative investments.

Why are alternative investments being considered for portfolios now more than ever? With inflation looming and interest rates set to rise off of all-time lows, investment professionals are exploring all options to confront a challenging investment environment. Adding exposure to investments that have exhibited lower correlations with traditional asset classes has become a more compelling course of action. Another timely boost for alternative investments is the growing advisory movement toward goal-based investing. The absolute return character of many alternative strategies fits neatly within the context of a client's return objectives. Not surprisingly, many advisors are beginning to think outside the box.

While the decision to add exposure to alternatives seems cut and dry, implementation has historically been complex (at best). Alternative investments have traditionally only been offered to high-net-worth accredited investors and institutions that can meet sizable investment minimums and standards. Liquidity and access to quality hedge fund managers has also been a problem for retail investors and their financial advisors due to limited partnership structures and extended lock up periods. Two other hurdles include the investment risk associated with the liberal use of leverage and lack of operational transparency.

However, in the words of American folk-rock icon Bob Dylan, "the times they are a changing." The continuing evolution in retail investment product development has expanded the playbook for advisors seeking to plug the alternative investment asset class into client portfolios. Now, increasingly high quality managers with proven hedge-fund track records are offering alternative strategies in an open-end mutual fund format with reasonable fees. The number of open-end funds with an alternative mandate increased from 50 five years ago to 130 as of August 31, 2009, according to Morningstar.

For example, AQR Capital Management, LLC (AQR), is a reputable asset manager entering the mutual fund business. AQR manages in excess of $17 billion across a variety of long-only and hedge fund strategies for institutional and accredited individual investors. The firm just launched its first mutual fund offering, the Diversified Arbitrage Fund (ADANX). For advisors who prefer a demonstrated public long-term track record, there are a handful of established open-end funds in the alternative category. Caldwell & Orkin's Market Opportunity Fund (COAGX), is a long/short fund that dates back to 1991. The fund has delivered on its performance and risk management objectives while offering diversification benefits to traditional long only portfolios. Even certain target-date fund providers are beginning to include alternative investments as part of their asset allocation strategies along the investor's glidepath. Mass affluent investors can thus gain appropriate exposure to strategies such as long/short equity, convertible arbitrage, and managed futures through their employer's 401(k) plan if these target date funds are offered by the plan sponsor.

While access to these strategies has improved through open-end fund opportunities, investors and their advisors are still faced with considerable due diligence and legwork to ensure that the most appropriate and highest quality alternative investment fund is selected. Importantly, advisors need to thoroughly vet the fund's investment strategy and understand how the portfolio's performance behavior and risk attributes will impact a client's diversified portfolio and what percentage of that portfolio should be allocated to the hedge fund or fund-of-hedge-funds vehicles. Open-end funds and ETFs, by nature of their registered vehicle, in many cases have difficulty replicating hedge fund strategies to their fullest extent. Additionally, advisors should prepare themselves to address issues such as relatively high expense ratios, a finite number of fund offerings, short track records, and limited portfolio transparency.

Indeed, finding high quality managers that fit the bill for inclusion in an investor's portfolio is no easy task, but in these turbulent market conditions we think it is time for financial advisors to roll up their sleeves, introduce thoughtful wealth management solutions to their clientele, and construct portfolios that can add measurable value in the quarters and years ahead.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital, which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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