A roundtable discussion moderated by AdvisorOne’s Jamie Green at the Schwab Impact 2011 conference in San Francisco on Wednesday tackled the increasing use of alternative investments by advisors and clients.
The roundtable featured participants from major alternative investment suppliers and included Andy O’Rourke and John Cadigan of Direxion Funds; Bob Worthington of Hatteras Funds; Brian Watson of SteelPath, and Rick Lake of Aston/Lake Partners LASSO Fund.
“The protesters represent a generation disenfranchised with equities and long-only strategies,” Cadigan began, referencing the Occupy Wall Street movement and sympathetic splinter protests in major cities throughout the country. “It’s a challenge for clients and advisors, but an educational opportunity for the industry.”
Cadigan added that baby boomers are transferring from wealth accumulation to distribution, and many are shying away from equities “given what recently happened, and advisors have well over 50% or so of their portfolios in fixed income. The strategies we represent help prevent the drawdown of their assets.”
Lake said the people with whom he speaks are concerned about three things: risk management, returns and diversification.
“In risk management, they want a smoother ride,” Lake explained. “With return, they are desperate for a source of returns in an unkind world. With diversification, they receive better risk-adjusted returns with our strategies than many traditional sources. We’re trying to get them away from, ‘What was up yesterday, and am I in it?’”
Worthington added that the advisors he speaks with want to mitigate risk and reduce volatility. They know volatility isn’t going away, at least in the foreseeable future, and alternatives are a hedge against volatility. But Worthington said he sees confusion on the part of advisors as to how to get returns versus a long-only strategy.
“They will use more alternatives, mainly in hedging strategies, but they will still need to deliver more return, and they’re still concerned about where those sources will come from,” he said.
“There is frustration with the markets, where clients think, ‘The more I get in total return the better, but I want it with less sensitivity to the S&P 500,’” Watson added. “That’s what we offer. We’re trying to validate that low risk aspect by buying managers that have low risk strategies.”
Green then asked participants if advisors were worried about fees and if they’re pushing back against the costs associated with alternative products and strategies.
Worthington said price is less of an issue with those vehicles with whucg advisors are familiar, and the industry will probably continue to reduce fees. Two-thirds of the advisors with whom Worthington speaks don’t mention fees, but the other one-third does. Whether or not fees come up is directly tied to the advisor's previous exposure to alternatives, he suggested.
“Three weeks ago I was at a conference where the advisors were trying to benchmark alpha in the traditional space with beta, and then comparing that to alternatives,” Cadigan said. “So there is a lack of understanding in the alternative space about the nuances in various exposures, let alone fees. What they really need is education on the various products and the competency of the managers managing those products.”
O’Rourke noted a two-tiered sales process. The first is to define alternative investments. The second is to then set expectations as to how alternatives will perform in certain markets. This second tier, he noted, is the harder of the two.
Cadigan added that investors want to see how alternatives would have performed in the 1980s and 1990s.
“The reality is the 1980s and 1990s were aberrations, so it wouldn’t be accurate,” he said.
“In a way it’s a very good time to be selling theses products because so many people still have recent memories of how the markets performed,” during 2008-2009, O’Rourke added.
Lake then mentioned that sophisticated advisors realize they will have to pay more money for expertise, and they will do it. But they also understand that there are some products that are relatively straightforward. Lake said it’s a bit “like buying at Target and buying at Tiffany’s.”
Worthington moved to a discussion of the focus on so-called “liquid alternatives” because of what happened in 2008.
“Many advisors don’t realize the 'illiquidity premium' will always be with us,” he said. “But many billion dollar teams are asking more for liquidity and once they get that they will do quite well.”
Lake added that advisors and investors have to diversify not only by asset class, but by varying degrees of liquidity.
“If you think you can build a portfolio with just alternative investments that are liquid, you won’t get the returns,” Worthington said. “A portion should be in liquid alternatives, but not all. One other point—just think if we had the market penetration in 2002 that we have today, when hedge funds and fund-of-fund strategies held up. It would be a much different conversation.”
Cadigan complained that absolute return strategies are in vogue, but the name completely misrepresents what they are designed to do, adding, “I’ll take a negative return of 19% versus a negative return of 37% any day.”
The discussion then turned to an examination of alternative investment performance in the most recent recession versus previous recessions, with Lake noting the bear market of 2000 to 2002 “was in many ways a dream bear market. It came on slowly, and kind of rolled through where some asset classes were up and some were down; versus the wood chipper of 2008 when everything got shredded.”
“We are hedged; we are insurance and insurance costs money,” Worthington said. “In an up market, clients may only experience 40% of the upside and think it’s not very good, But let’s remember what this is for.”
"Clients are not benchmarked like they were in the 1980s and 1990s,” Cadigan added. “Now it’s about getting to where they need to be.”
Watson said that he sector in which SteelPath resides, a number of firms launched funds in MLPs and tried to take advantage of very specific subsectors. But the space couldn’t support them, he claimed. He added that clients need to realize they own good names and to be patient, but that’s a tough story to tell.
“But 2008 is a good marketing tool for us,” he said. “We say, ‘If you had these names in 2007, by 2009 when the dust settled they looked pretty good.’ So let’s remember what these are for.”
“Most people today make money, rather than inherit money,” Cadigan added. “They took a risk in business and now that they've [sold those businesses] cashed out, they don’t want another [risk]. But when we explain these products most people immediately think Madoff.”
Green concluded the session by wondering if the term “alternative investment” is misleading.
“There really are only four major asset classes: equities, fixed income, currency and commodities,” Worthington answered. “I think that five years from now 'alternative' will apply to a lifestyle rather than investing, because many of these products no longer are alternative.”
“Sure, and five years ago it was all about hedge funds. Now that term is almost quaint and it’s all about alternatives,” Lake answered.
“It really comes down to taking alternative investments and traditional investments and putting them in a strategy that works in either market direction,” Cadigan concluded.