September 17, 2013

3 Reasons Advisors Are Wary of Alt Investments

Many advisors are still wary of alternatives. Should they be?

The threat of rising interest rates, ongoing cyclical volatility and increasing correlation has investors in a desperate search for alternatives to traditional investments.

Recent analysis by Pension & Investments found that from the start of 2011 through mid-2012, investors made a total of $94.6 billion in alternative investment commitments, including real estate, compared with $79.6 billion to equities and fixed income.

This compared with only $15.4 billion committed to alternative investments and real estate just eight years earlier in 2003 by North American investors, according to the magazine. In that same year, it added, investors made $65.9 billion of combined investments in equities and fixed income.

Despite this proverbial perfect storm for alternative investment success, some advisors are still wary, due in part to misconceptions about the alternatives industry (and alternative funds in particular), according to a soon to be published survey by State Street. Transparency, regulation and the development of new products and structures are areas of ongoing confusion and concern, according to the firm.

But as the mainstreaming of this asset class continues, it should “debunk common misconceptions that have hindered opportunities for investors and fund managers alike,” according to George Sullivan, executive vice president and global head of State Street’s alternative investment solutions.

Keep reading for what State Street says are the biggest misconceptions about alternative investments, and how advisors interviewed by ThinkAdvisor responded to the list:

Misconception: Alternative fund managers have been reluctant to offer greater transparency into fund performance and risk.

"This, to me, is one of the biggest issues advisors have to deal with, especially when it comes to limited partnerships," says Dave D'Amico, president of Boston-based Braver Wealth Management. "This is how you get a Madoff situation. Without transparency, the manager can really do anything and you have no way of knowing. You can't look a client in the eye and build trust without knowing what's in the portfolio."

Reality: State Street argues the reality is that managers are reporting more information to investors, more frequently.

“Forty-four percent of fund managers have increased the amount of information they report on their holdings, risk and performance since 2008 and an additional 16% plan to do so over the next five years. Almost one-third (32%) have increased their reporting frequency since the financial crisis.

Well, they’ve had to,” counters Fred Taylor, president and co-founder of Denver-based Northstar Investment Advisors. “Because so many of the strategies involve shorting the market, they’ve significantly underperformed traditional, long-only managers. Many hedge fund strategies, in particular, have rebranded themselves as alternative investments because it doesn’t sound so pejorative, quite frankly.”

Misconception: The era of major change in the alternative sector is largely finished.

Reality: State Street says growing competition means that alternative fund managers are reassessing their fee structures and seeking ways to differentiate their offerings with new product and investment strategies. Twenty-nine percent of alternative fund managers surveyed indicated they planned to add new investment strategies with in-house resources over the next five years, while 25% said they have done this since 2008.

"I don't think innovation is finished at all," D'Amico agrees. "I think we're at about the midway point, and it will continue for the foreseeable future."

And the fee structures State Street mentioned, of course, are a major (and ongoing ) issue.

“Alternative investments have historically been extremely expensive,” Taylor notes. “From 1990 through 2007, alternative strategies, and hedge funds in particular, performed great. But since the crisis in 2008, they’ve charged high fees and performed terribly.”

Misconception: Alternative industry regulation is stifling growth and innovation.

Reality: Although burdensome for many, the new era of heightened regulation is also creating opportunities for managers to distinguish themselves from peers and tap into investor appetite for increased transparency and oversight, State Street says. Of the 86% of alternative fund managers who expect their costs to increase over the next five years, largely driven by regulation, 75% are optimistic that this will not constrain their growth potential.

Mark Singer thinks that’s too optimistic. The president of Safe Harbor Retirement Planning, based in Lynn, Mass., says he’s failing to “gain traction" with liquid alternatives because the prices keep changing. On the illiquid side, he’s “handcuffed” by regulations that dictate the amount he is able to include in the client portfolio.

“I could put 75% into a liquid product offered by PIMCO or AQR,” he explains. “But I couldn’t go anywhere near the same allocation in an illiquid format. I understand the need for liquidity, but what are they really talking about: risk, liquidity, what? We see great potential, but the regs are holding us back.”

State Street concludes by listing a number of future trends it sees from the survey:

Regional expansion: Nearly one in five fund managers (18%) surveyed plan to expand into new regions by 2018.

More managed accounts: More than one in four (26%) have introduced managed accounts in the past five years, and another 18% plan to do so by 2018.

More hybrid funds: A majority of respondents (58 %) say that hybrid alternative fund structures, which blend features of traditional hedge fund and private equity vehicles, will increase over the next five years.

M&A activity is set to increase: 10% of fund managers plan to acquire another business in the next five years; this compares to 7% who have already done so in the past five years.

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