From the May 2014 issue of Investment Advisor • Subscribe!

Alternative Access: A New Market for High-Demand Products

Millennium Trust provides advisor access to non-traditional investments

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Broker-dealers and custodians are wary of alternatives, but advisors need them to compete. Broker-dealers and custodians are wary of alternatives, but advisors need them to compete.

There's a lot of confusion these days about alternative investments. For instance, when the Investment Company Institute recently “modernized” its classifications for retail mutual funds, it added an alternatives investment strategy in each of its domestic equity, world equity, hybrid and bond categories. However, the ICI defines “alternatives” as strategies that provide capital appreciation while minimizing risk with “long-short, market-neutral, leveraged or inverse strategies.” Those may be your father's “alternative” investments, but they certainly aren't what today's investors and advisors usually mean by that term.

It's also not what McKinsey & Co. meant when it released a research report titled “The Mainstreaming of Alternative Investments” back in June 2012. McKinsey's definition of alternatives included hedge funds, private equity, real estate, infrastructure and commodities.

We can add private debt, crowdfunding, peer-to-peer lending and so-called “social” and “green” investing to that list, but McKinsey's claim of alternatives changing retail asset management is, if anything, even truer today.

For independent advisors, the resurgence in popularity of the these true alternative investments since 2008 has created something of a conundrum: Without offering them to clients, advisors find it's increasingly difficult to compete with wirehouse brokers, yet due to issues with liquidity and valuation, traditional custodians and BDs have largely declined to provide access to alternatives, except through ETFs and other indexed products.

That is exactly why Scott McCartan launched the Millennium Trust Company in Oakbrook, Ill., in 2000. “Back when I ran First Chicago Bank, the last thing I wanted to see coming in the door were clients with alternative investments,” he remembered. “They were a pain to deal with. You have to retool your technology systems to handle them. But as time went along, the alternatives proved to be a much better diversifier of client portfolios—and they were posting some pretty good returns. I realized that RIAs and their custodians also had problems with alternatives and saw an opportunity.”

Here's how the McKinsey report described that opportunity and why it's important for independent advisors to take it seriously:

  • Global alternative AUM across retail and institutional segments doubled between 2005 and 2011 to $6.5 trillion “despite a very public flame-out during the [2007-2009] crisis. This represents a compounded annual growth rate of 14% over the period,” seven times that of traditional asset classes.

  • U.S. “retail alternative assets and alternative-like strategies such as commodities, long-short products and market-neutral strategies have grown by 21% annually since 2005.” Alternatives are not simply growing; they are becoming part of the investment management mainstream. That's due to increasing adoption by retail investors and a shift in investor benchmarks from relative to absolute returns.

  • By 2015, alternatives will likely account for 13% of U.S. retail fund assets, one-quarter of retail revenues and a majority of revenue growth, as retail investors, confronted with volatile financial markets and underfunded retirements, follow the path blazed by institutional investors.

  • “Fully 100% of U.S. [asset managers polled] in McKinsey's research […] expect alternatives will grow faster than traditional asset management products.”

  • Traditional asset managers will need to embark on a major shift in their operating focus, away from the relative return investment framework and well-defined boundaries (e.g., style boxes, long-only products) toward managing investments to an absolute return target or objective.

Millennium Trust opened direct alternative investing to independent advisors and their clients. “While many financial institutions handle stocks, bonds, mutual funds and ETFs,” McCartan told me, “Millennium Trust is able to go far beyond that standard menu. We are one of the few independent trust companies that specialize in the custody of alternative assets in addition to traditional investments—and the only one I know of specifically designed to work with independent RIAs.”

Millennium's platform is designed to handle documentation and account administration for investments in hedge funds, advisor-managed funds, limited partnerships, private equity, private stock, real estate, mortgages and trust deeds, promissory notes, futures, limited liability companies and other private investment structures, and gold and other precious metals.

“When we started Millennium Trust, alternatives weren't used a lot by RIAs,” said McCartan. “But they are being used more and more these days. In fact, that business continues to grow like a weed. At the same time, all of the large custodians have issues over alternative investments. Since the Bernie Madoff scandal, their legal people don't like them getting involved in non-traditional investments. We picked up about 1,000 RIAs back then who were in alternatives and got kicked out by their custodians.”

He continued, “Of course, the custodians realized that wasn't too good for business, so they started referring their advisors to Millennium to custody their alternative investment holdings,” McCartan said. “So we don't compete with the big RIA custodians; we work with them so they can keep their advisors and their advisors can continue to offer alternatives to their clients.”

Not only were McCartan and his team in the right place at the right time to pick up RIA business turned away by custodians, they also nailed the timing on the exploding alternative market. “Today, there are literally hundreds of thousands of alternative investments, many of them spawned by the JOBS Act. Suddenly, all these online trading platforms were connecting accredited investors with attractive investments. Alternatives are being pursued over the Net. We see many RIAs today going to these platforms to find attractive opportunities for their clients—there's a lot to choose from—and they all need a custodian to hold this stuff. We give them a seamless integration with their current custodian and technology platform.”

Of course, direct alternative investments raise two rather serious issues that independent advisors have largely been able to avoid for more than two decades: hands-on due diligence and portfolio liquidity. Direct alternative investments are usually illiquid. They often have restrictions on when—and how much—client money can be withdrawn. So financial plans need to reflect these realities. What's more, this also usually means those holdings aren't valued every day (like mutual funds or ETFs), and sometimes aren't valued at all for extended periods.

Consequently, advisors need to take into consideration that AUM fees based on current market valuations can be problematic. Millennium solves this problem by charging flat fees for the custody of client accounts. “You just don't know what many of the holdings are worth,” said McCartan. “Getting up-to-date valuations takes a lot of work. And, of course, it varies by asset. For instance, valuing real estate is often harder than a limited partnership or debt.”

Millennium Trust charges a maximum of $350 annually per client, regardless of the size of the account.

Then there's due diligence. Determining the quality of privately held investments can entail a bit more than running a Morningstar report, especially when opportunities can vary significantly more widely than small cap versus large cap. “There are a lot categories of alternatives,” said McCartan. “Often, you have to dig for information: Who's doing it? What's their record at it? At Millennium, we go out of our way to not provide information or due diligence. That's not our area of expertise. Fortunately, our advisors don't have to be an expert on coffee plantations in Brazil, either. Many large institutions are creating their own products, such as UBS Alternatives. Then they’re going directly to the hedge funds or funds of funds.”

The good news for advisors is that large institutions are used to working with institutional investors—and providing institutional-quality due diligence reports. But when it comes to smaller private deals, it's probably going to take a lot more work.

In the wake of the market meltdown of 2008, many independent advisors started questioning the wisdom of limiting client portfolio allocations to stock and bond mutual funds. Some five-plus years later, it looks as if the emerging answer is the addition of direct alternative investments. At least, that's what the McKinsey data suggests—and Millennium Trust's success confirms: It now has over $10 billion under administration (doubling every 2.5 years) in some 300,000 accounts. About 1,000 RIAs use Millennium's custody services, and more than half are larger than $1 billion in client AUM. The bigger firms may not know everything, but they do know how to compete with wirehouses to attract HNW clients.

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Correction: The print version of this article incorrectly stated Millennium Trust's fees in a quote. This article has been changed to correct that.

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