I don't know if he still does this, but years ago, my old boss Don Phillips (now president of research and communications at Morningstar, Inc.) used to travel around giving brilliant presentations about the outperformance of mutual fund managers who couldn't be contained into one style box. I can't remember all his examples, but the ones who stick in my mind are Foster Friess of Brandywine Fund, Jean-Marie Eveillard of SoGen International, and gruff old cigar-smoking Marty Whitman of Third Avenue Fund.
Don would dip into his Morningstar fund data, and regale standing-room-only audiences with example after example of how, over the years, Whitman & Co. had periodically repositioned their portfolios across the investment spectrum to capture whatever opportunities they saw in their crystal balls: from corporate bonds to value stocks; and emerging markets to U.S. real estate. In doing so, their results led the mutual fund industry time after time after time.
Don's point was that great money managers could feel undervaluation in their bones, and fearlessly followed their instincts whereever they led. Not coincidentally, he was also graphically illustrating the flaw in the Modern Portfolio Theory approach that most independent advisors use to allocate client assets. By doggedly looking for funds that rigidly adhere to a corner of the style box (which, ironically, was created by Morningstar), advisors handcuff managers by preventing them from taking advantage of all the opportunities they see, or ignoring the great managers who do.
Fast forward to late 2008, when all the major asset classes (except Treasuries) took an unprecedented nosedive, and that MPT flaw was exposed in a way that most advisors couldn't avoid noticing. The entire industry has spent the past year or so wrestling with the question of what to do about it. Some folks believe that a broader basket of asset classes would have dampened the impact of the Mortgage Meltdown. Others are turning back toward market timing, I mean "strategic allocation," under that hard-to-argue-with notion that if we could just avoid those pesky market downturns, we'd all be a lot happier.
Another approach that seems to be getting a lot of attention from advisors these days is the way institutional and high-net-worth investors have traditionally solved this problem: They reduce risk and still keep portfolios quantifiable by adding low-correlating asset classes while allowing fund managers to take short as well as long positions within their fund parameters. Yes, I'm talking about managed futures and hedge funds here, but before you turn back to your Morningstar Workstation, you might want to look at some of the recent market data--it could change your life.
For starters, let's consider the past 10 years, ending March 31, which includes two major down markets that I'm sure you and your clients clearly remember. While the S&P 500 Index (total return) was losing 6.36%, or 0.66% per year (that's right, your clients' diversified equities probably lost money over the past decade despite last year's run up), hedge funds (as measured by the HFRI Fund Weighted Composite Index) were up 77%, or 5.9% a year. They nearly doubled in value. And managed futures (by the Altegris 40 Index) were up 115% or 8.0% annually.
Got your attention? Well, it certainly got mine. Sure, with both the dot.com and subprime crashes it was a very tough decade for equities. But that's the point: How do advisors better protect client portfolios from the market downturns that seem to inevitably occur every seven to 10 years or so? Managed futures and hedge funds seem to offer a pretty compelling answer.
What about compared to real, diversified portfolios? Take a look at the chart below, which compares a $1 million portfolio traditionally allocated between 70% equities (S&P 500) and 30% bonds (Barclays Capital US Aggregate Bond Index) with $1 million split: 45.5% S&P, 19.5% US Bonds, 20% Managed Futures, and 15% Hedge Funds. As you can see, the results aren't as staggering, but the portfolio with the alternative investments still outperformed dramatically. During the same 10-year period, the traditionally allocated portfolio returned a mere 18.2%, while the addition of 35% managed futures and hedge funds boosted performance by nearly 150%, to a 45% total return. And that with a 28% lower standard deviation (8.0% vs. 11.1%), and the "worst drawdown" (largest spread from peak to valley) reduced 29%, from -37.6% to -26.7%.
Of course, identifying promising new investment strategies is only half the battle--particularly when they're traditionally institutional. For independent advisors, the bigger challenge is finding investment vehicles that can accommodate their less-than-high-net-worth clients, and still capture those institutional advantages, all at a reasonable cost. When it comes to managed futures and hedge funds, the challenge is even greater.
Two years ago, Mike Capelle, senior vice president of investment management at United Capital Financial Advisors in Newport Beach, California, realized that to attract the affluent clients who are his firm's target market, he needed to offer more institutional- level investments. United Capital is a "national" wealth management firm, since 2005 consolidating some 23 advisory firms across the country, collectively managing $9 billion in client assets. With a focus on what they call "private wealth management," United Capital needed to compete with the private banks, which then--and even more so now--meant access to hedge funds and managed futures.
To meet that growing client demand, Capelle turned to Altegris Investments just down the road in La Jolla. Altegris is the brainchild of Jon Sundt, a former director of managed investments at the Mann Group (the world's largest hedge fund provider), who eight years ago realized that the growing number of smaller family offices and affluent investors lacked the necessary minimum investments for some of the larger "name" alternative portfolios. So he created pooled hedge fund and managed futures vehicles to provide access to the best funds, at reasonable fees, using institutional level screening, selection, and monitoring of participating funds.
He also created a platform with data and analysis tools to help clients with less-than-institutional resources create sophisticated portfolios. The response among knowledgeable folks who manage high-net-worth money was predictably good, with a boost from the markets in 2008. Altegris now offers some 20 alternative investment strategies that have attracted $2.5 billion.
One of United Capital's five core model portfolios contain two Altegris managed futures funds, and Altegris managed futures and hedge funds are available for United's advisors to use in their individually customized portfolios as well. Even though the United Capital advisors have the ability to alter the model portfolios they use, virtually all the firm's advisors use the Altegris funds in at least some of their client portfolios. "Non- or low-correlating assets that historically perform well in down markets are very attractive to our advisors, and our clients," says Capelle. "We've been very happy both with the performance of the Altegris funds, and with the reception they've received from our advisors."
Based on his success with United Capital, and other indications of interest, last year Sundt opened his alternative investment platform to independent RIAs and registered reps of independent B/Ds. Unlike his original market--the family offices and wealthy investors who are attracted by the ability to get into hedge funds they've heard of--Sundt realizes that independent advisors will need to hear more about how hedge funds and managed futures make client portfolios better: higher long-term performance with lower risk--which is why he's launched a new program to create and publish research on historical performance models and information on using alternative investments to create optimum client portfolios.
Both Sundt and Capelle talk at length about what advisors need to know to integrate alternative investments into client portfolios, and to adequately explain managed futures and/or hedge funds to their clients. Alternative investments typically require qualified investors, and often limit liquidity to monthly withdrawals rather than the daily access clients are used to with mutual funds. And some partnerships require K-1 filings, which is why Capelle uses managed futures--which do not--in his core portfolios.
To help advisors get a better handle on why and how to include alternative investments in client portfolios, last April, Altegris held its annual Strategic Investment Conference in La Jolla. It sold out at 350 attendees, almost half of whom were independent RIAs and registered reps.
"We could easily have had 1,000," says Sundt, "if we'd had the space. A lot of people want to know what to do right now. Some experts are predicting inflation, others deflation. If all you have is beta to work with, how are you going to protect your portfolios?"
The answer that both Mike Capelle and Jon Sundt have come to is to identify the smartest investors in the world, and give them a free hand: to invest in a broad range of asset classes, and to take both long and short positions in them. It's an idea whose time should have come at least 10 years ago. And I suspect increasing numbers of independent advisors will be exploring it--as they explore how to create safer client portfolios and try to compete with the private banks for more affluent clients.
Bob Clark, former editor of this magazine, surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at email@example.com.