Top 10 Dangers of Alternative Investments

At the IMCA Conference, Chris Cesare of Rocaton Investment Advisors says due diligence is more important than ever in an alt universe fraught with hazards

Man reacts to results on stock board. (Photo: AP) Man reacts to results on stock board. (Photo: AP)

“It’s a big world out there.”

A salient observation in its own right, and the title of a Tuesday morning session at IMCA’s national conference in National Harbor, Md., but it's even more so when trying to comprehend alternative investments and their role in the client portfolio.

Presented by Chris Cesare of Rocaton Investment Advisors, the session was broken into three parts to help advisors in the audience digest what is too often an overwhelming task: evaluating appropriate alternative managers and products. The three parts were a review of alternative investment strategies (including management and structure of the investment vehicle), a discussion of why advisors should even bother with alternative investments and, lastly, the role of proper due diligence in the selection of a product.

Cesare began by defining the alternative investment universe, which he said contains 7,000 hedge funds, 1,800 private equity funds and 500 real estate and infrastructure funds.

“How should you think about the alternative investment universe?” he asked. “”It’s similar to how a scientist considers the galaxy. There’s been a lot of press lately about zones of life that might support something like ourselves. It’s the same with the appropriate zone for alternative investments within the portfolio.”

But, he warned, there is a large range of potential outcomes; the potential for great returns, and also the potential for great embarrassment with clients when a “down draft” occurs, which is why the evaluation of the alternative product’s manager is so critical.

Cesare then offered up 10 pitfalls that could result in an unpleasant outcome when employing alternative investments:

Trader on the floor of the NYMEX. (Photo: AP)1) The famous “2 and 20” fee structure will always apply, even if returns are mediocre, something that’s exacerbated in the alternative space.

2) The management team leaves for another shop after due diligence has been performed

3) The wrong strategy is employed at the wrong time

4) The right strategy is employed at the right time, but the manager has the wrong implementation

5) Risk (mis)management

6) A mismatch occurs between the product's assets and liabilities

7) The manager is distracted by expensive planes and swanky boats

8) Fraud

9) Side pockets, SPVs and SLVs that further reduce liquidity

10) The manager experiences style drift from the product’s original thesis

“Did I mention ‘2 and 20,’” Cesare said to emphasis the importance, and potential danger, of the fee structure.

Moving on the second point of his presentation, Cesare asked: “Why bother?”

The role of alternatives is to provide for the potential for “return enhancement,” he said. It should also provide for the potential for risk reduction. Lastly, it should provide for exposure to a larger “opportunity set.”

“The essence of alternatives is that they have to bring something to the table that the client doesn’t already have,” Cesare added. “Alternative investments are not an end in themselves; they are not a silver bullet or panacea for all that’s wrong with a portfolio, but they have an important role to play.”

The last point of the presentation, the importance of due diligence, began with Cesare’s list of the components of his firm’s typical due diligence process.

  • Sourcing: Third-party research on the product
  • Qualitative due diligence: The investment philosophy and process, as well as the management team’s quality and structure
  • Quantitative analysis: A hard look at the numbers
  • Market opportunity assessment: What’s ahead for the product
  • Post-investment monitoring

“The role of due diligence is to increase the probability of achieving the stated objectives and decrease the probability of unpleasant outcomes,” he concluded. “We don’t seek to hit home runs, but at the same time we don’t want to be swept over the course of a weekend series.”

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Check out Alternatives & Annuities: The Right Mix for Advisors?

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