February 16, 2012

Risk on the Rise: Yield Chasers Rush Into Alternatives

Milton Ezrati, Tony Davidow, IndexIQ, Fred Alger contemplate risk vs. reward

One day in late January at the Investment Management Consultants Association’s annual New York conference, Lord Abbett market strategist Milton Ezrati got a big laugh from the audience of nearly 1,000 financial advisors when he recalled a recent visit to the Occupy Wall Street encampment in Zuccotti Park.

Milton Ezrati, Lord, Abbett & Co. market strategistAs he watched the swirl of placard-carrying protestors chanting in the park, Ezrati (left) realized the ideas that drove them to demonstrate were more complicated than he had originally imagined. This thought came to him, he said, when he saw one obviously savvy protestor bearing a sign that carried this punch line: “Stop Correlation.”

Over the course of 2011, advisors have watched in frustration as the value of investments ranging from large-cap U.S. stocks to emerging markets stocks to oil to gold have been rising and falling in tandem. This high degree of cross-asset correlation reduces portfolio diversification as it increases volatility.

“Given continued uncertainty in European and U.S. markets, investors expecting heightened market volatility in 2012 should expect correlation extremes to persist,” says Factor Advisors, a New York-based asset management firm, in a market report titled “2011: A Year of Correlation Extremes.”

Correlation Drives Advisors to Alternatives

Cross-asset correlation reduces portfolio diversification as it increases volatility, says Factor Advisors.Correlation, coupled with the U.S. bond market’s zero-yield environment, has driven advisors into riskier alternative investing. Indeed, since the Federal Reserve announced that it will keep its benchmark interest rate near zero until 2014, advisors often find themselves moving into higher risk territory due to client demand.

Bradley Teets, a certified financial planner in Punta Gorda, Fla., noted in a recent market commentary that retirees who previously earned 5% to 6% on conservative investments could expect income of about $5,000 or more annually for each $100,000 in savings.

“Now, if they earn 0.5% on savings, they have new income and cash flow of $500 to $600 annually if they are lucky and search out the best interest rates for their money,” Teets wrote. “Savers needing more income will be forced to bear more risk to chase yield from alternative investments.”

Traditionally, alternative investments such as hedge funds, derivatives, commodities, international currencies and managed futures have been held by institutional investors or high-net-worth individuals. But as high correlation persists, alternatives have been gaining in popularity with a wider range of investors and advisors.

Steve Enos, a principal and founder of San Francisco-based Cypress Wealth Advisors, says that more of his HNW clients are investing in alternatives such as master limited partnerships and real estate investment trusts to improve income.

Fed Policy Increases Willingness to Take on Risk

“If the Fed is going to keep rates low, you can’t keep your assets in a money market account, so you have to put it out where there’s some risk,” Enos said. “What clients are asking for is more return or more income, especially as bonds mature where they were getting 4%, 5% or 6 % yields and they’re now looking to reinvest at 2%, 3% or maybe 4%. It’s a tough quandary.”

Ideally, alternatives should dampen portfolio volatility when markets go down, but they should also retain upside potential when markets go up, according to Adam Patti, CEO of New York-based exchange traded fund firm IndexIQ.

While many investors would be happy to simply move their money into cash, it’s not such a great option these days because CDs and money market funds aren’t even keeping pace with inflation, said Patti, whose firm designs ETFs that replicate hedge funds.

“The better option is to have a good asset allocation strategy that includes diversification. The problem, of course, is that retail investors haven’t had access to education,” he said. “For example, many people still think hedge funds are designed to shoot the lights out with performance. But they’re called hedge funds because they’re designed to hedge, not produce 100% returns.”

Davidow Sees Advisor Desire to Hedge Volatility

“More and more advisors are looking for ways to insulate their clients from those choppy movements,” said Tony Davidow, managing director and portfolio strategist with Guggenheim Investments (and an IndexIQ veteran). “Due to the market volatility, advisors are interested in alternatives. We see it as the democratization of alternatives.”

In a paper on currency alternatives, Davidow advocates foreign exchange as an alternative investment, saying forex has historically shown low correlation to traditional investments while providing a way to diversify cash.

“The forex market is the largest, most liquid market in the world, and it’s the most efficient market in the world,” Davidow said in a phone interview. “It’s easy to access for the big boys, but being able to buy our currency shares ETF democratizes the average advisor’s access.”

To be sure, many new alternative products have come to the fore in the last year as yields have languished. Cerulli reports that alternative investment strategies are leading new product development plans geared for the U.S. retail third-party channel.

“I’d emphasize the word ‘new,’” said IndexIQ’s Patti. “Many of these fund companies struggle to outperform their benchmarks with traditional long-only strategies, let alone alternatives. How in god’s name are they going to succeed with a long-short strategy?”

One such fund, the Alger Dynamic Opportunities Fund (SPEDX), marked its inception date on Nov. 2, 2009 and has $22.7 million of total fund assets as of Dec. 31, 2011. The fund manages volatility of a sector, industry, or individual security through short sales, options or other derivatives.

The front end load is relatively high, at 5.25%, as is the expense ratio, at 3.30%, while the fund’s lifetime performance is 3.61%. But SPEDX portfolio manager Greg Adams said investors in his fund can reap the benefits of long-short risk typically found in hedge funds while enjoying the liquidity and transparency of the mutual fund marketplace.

“People get concerned about long-short when hedge fund risk is leveraged, but this is a product that does not get involved in significant amounts of leverage,” Adams said.

Regulation and Education

The Financial Industry Regulatory Authority (FINRA) on Jan. 31 released its 2012 regulatory and examination “watch list,” which said the regulator will be zeroing in on products that aren’t suitable for some investors. Among the products on the list are alternatives such as non-traded REITs, complex exchange traded products, structured products and private placements.

According to AdvisorOne’s story about the list, FINRA said the “challenging economic environment can lead individual retail investors to be susceptible to recommendations to chase yields without necessarily understanding the risk-versus-reward tradeoffs.”

With currencies just one example of the alternatives available to yield-chasing investors, yet another opportunity has opened up in the space: the need for education.

Altegris, a subsidiary of Genworth Financial Inc., on Feb. 1 announced a new website, Altegris Academy, with interactive tools to help advisors build portfolios using alternative investments. Future updates to Altegris Academy will include an Advisor Continuing Education Center offering CE courses and credit.

Given what the markets have gone through over the past few years and the continuing search for yield, alternatives are an inevitable choice for many. And investors are focused on downside protection and risk management above overall returns, noted David Vincent, vice president of alternative product sales at Alger.

“You have this surge of new products from companies coming out into the market,” Vincent said. “You have to be skeptical and do your own due diligence, which can be daunting for investors. It’s an exciting time for investors to be in the space because there are so many opportunities and a scary time because there are so many opportunities. This is going to be a big educational year for people.”

Read a War of Borrowers Against Savers news analysis at AdvisorOne.com       

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