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The Other Way

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After nearly four years of a bear market in equities, investors have been pounded and they’re desperately seeking investments that will yield decent returns. As a result, more and more advisors are finding that alternative investments–hedge funds, funds of funds, private equity, venture capital, real estate, private REITS, oil and gas limited partnerships, and commodities–are providing a much-needed jolt to clients’ portfolios. “Combining alternatives with traditional investments reduces the client’s risk and increases their return,” says Gary Greenbaum, president of Greenbaum & Orrechio, Inc., in Old Tappan, New Jersey. Advisors “should always consider” alternative assets, concurs Michael Joyce, a CFA with Michael Joyce & Associates in Richmond, Virginia. “At least a portion of clients’ portfolios–no more than 5% to 10%–should go into alternative investments.”

The Institute for Private Investors’ recent Family Performance Tracking Survey supports these conclusions. It found that a growing number of high-net-worth individuals are embracing alternative investments. Thirty-seven percent of the survey respondents said they invest in alternative investments, including hedge funds, private equity, and venture capital. And 53% of those responding said they plan to increase their hedge fund investing in 2003. Each of the 71 IPI member families polled, which represented 24% of IPI’s membership, have investable assets in excess of $10 million.

While the number of advisors using alternative investments is growing, there are still those like A. Todd Black, president of Dogwood Capital Management, Inc. in Cumming, Georgia. He is not putting any of his clients’ money into alternatives because he believes they’re a “gimmick.” Too many advisors, he says, are lured by alternative investments’ status as “the hot new thing,” and are hung up on giving clients the impression that they’re “on the cutting edge.” Black worries, too, that advisors “are telling their clients to keep focused on the long-term while they turn over stones looking for the hot new product that they can throw into the asset allocation and make a quick buck.” And he says, performing due diligence on many alternative investments is next to impossible, “which makes them a big liability for advisors if they use the wrong ones.”

Indeed, Greenbaum says that the way Wall Street packages alternative investments “as a miracle” is a gimmick: “They have warts, like high prices and conflicts of interest.” But he says these investments “have a very fundamental benefit,” which is their negative correlation to the stock market. “Correlation coefficients–how asset classes move–are becoming more and more similar,” Greenbaum says, “so small, large, international and domestic stocks are all behaving alike. That’s bad.” A negative correlation is good, he says, because it reduces risk. “If you want to focus on reducing your portfolio risk, you’ve got to use alternatives. There’s no other choice,” he says. But he cautions that an alternative investment is only beneficial if the advisor can reduce the client’s risk after factoring in taxes and costs.

More Scrutiny for Hedge Funds

Hedge funds have become the most popular alternative route for advisors and their clients. In fact, new funds of hedge funds are popping up nearly daily. But some regulatory constraints on hedge funds and funds of funds may be just around the corner; Securities and Exchange Commission Chairman William Donaldson has become alarmed over hedge funds with lower minimum investments that allow more retail investors in the door. He plans to hold a hedge funds roundtable this month. And Rep. Michael Oxley (R-OH), Chairman of the House Financial Services Capital Markets Subcommittee, plans hearings to discern whether hedge funds are appropriate at all for retail investors.

Rydex Capital Partners is the latest entrant into the funds of funds community with its SPhinX Fund, which is based on the Standard & Poor’s Hedge Fund Index. Deutsche Bank, UBS Painewebber, Morgan Keegan, and Raymond James have also launched hedge fund products that track the S&P index. Chuck Tennes, director of portfolios for Rydex, says that SPhinX will be structured as a registered, closed-end fund. It will not trade on an exchange, he says, and sales will be limited to accredited high-net-worth investors. And because Rydex is targeting RIAs, the fund will be no-load; the fund’s expense ratio is expected to be 1.95%. SPhinX will also have significant limits on liquidity, Tennes says; Investors will be allowed to put money in monthly, but redemptions will be allowed only quarterly. Moreover, “we expect to have a lockup at the beginning–probably a full year” before new investors will be allowed to cash out, he says. However, investors will always be able to obtain daily valuations from figures provided by PlusFunds Group Inc.

Rydex’s SPhinX Fund is, in fact, a pool of capital that feeds into a managed account run by PlusFunds Group Inc. in New York. PlusFunds Chairman Christopher Sugrue currently manages $420 million spread among the 40 managers in the S&P Hedge Fund Index. By contractual agreements, the PlusFunds allocations are designed to be exact duplicates of the hedge funds’ own holdings–and each individual manager runs about $600 million in its own portfolio. The fund started with $250 million from a Bermuda-based reinsurance company, and Sugrue has since raised additional money from banks, pension funds, and high-net-worth individuals. New entrants to the fund, such as Rydex and Deutsche, “have set aside $100 million of investment capacity,” and some plan to go up to $200 million, Sugrue says. He hopes to build the fund up to $5 billion in the next three years.

Why is Rydex using the intermediary of a PlusFunds managed account? Because the 40 PlusFunds accounts with individual hedge fund managers mirror their own portfolios, PlusFunds can see all their investments and daily activities. While it won’t reveal them to the public, it does use them to come up with daily NAV. “PlusFunds operates the infrastructure that allows the whole thing to work,” says Sugrue. To double-check pricing, PlusFunds gets valuations from outside brokers every month on portfolio securities that haven’t traded.

Hedge funds aren’t the only alternative, of course. Gene Balliett, a planner with Balliett Financial Services, Inc. in Winter Park, Florida, considers himself a newcomer to the alternative investing world, and oil and gas limited partnerships and real estate have caught his eye. “We’re looking at ventures and deals,” he says. That includes oil and gas private partnerships structured by Five States Energy Company in Dallas, and real estate properties developed by Capital Income Properties in Newport Beach, California. Both companies offer no-load instruments.

No Promises

Capital Income is now building two or three shopping centers in California, Balliett says, and “they secure all the engineering and environmental studies and talk with the town council and zoning board and put up all the money for that. They don’t go to investors until they’ve got everything approved and ready to go; then, having eaten that risk with their own money, they are looking for investors to put money in so they can do a bigger deal than they could with their own money.” Balliett says he’s looking for no-load deals with “people I know and am comfortable with.” And before he invests his clients’ money in any alternative strategy, he invests his own money in the venture first. That way “I can say [to the client], ‘I can’t give you any promises, but I’ve already invested in this.’”

The Wells Real Estate Investment Trust Inc. is a favorite of Robert Bubnovich, a fee-only planner with Rio Financial Advisors in Irvine, California. “If there were ever a ‘no-brainer,’ this is it,” he says. He invests his clients’ money in the Wells private REIT for three reasons, he says: it’s an alternative to stocks that maintains a significant yield spread–7% current dividend–over money market rates; it has a high credit quality of tenants; and it has a low principal risk or potential for appreciation if an IPO happens.

Michael Joyce with Michael Joyce and Associates likes to put his high-net-worth clients’ money in private equity, venture capital, hedge funds of funds, and managed futures. Right now, he favors private equity funds that invest in cash-flow producing companies over seed-stage funds. He’d like to get “a mix of both,” he says, but many of the seed-stage funds “invested in bad business models and paid high valuations, and that’s taken up a lot of their time and energy to nurse some of these surviving companies.” The majority of Joyce’s clients are accredited investors, and they’re the only ones suitable for private equity and VC deals. Clients need to have a long-term time horizon to invest in private equity and VC, Joyce says, “because we’re telling them it’s going to take three to five years to invest the funds, and 10 to 12 years before they see realization of proceeds; they’ll start to get proceeds after four or five years, but it might take 10 to 12 before they get the majority of their return.” These clients also must have a high risk tolerance, and “the ability to have a small portion of their portfolio illiquid.”

Joyce uses hedge funds and managed futures in clients’ portfolios to manage risk, rather than to enhance returns. “Hedge funds are often misclassified as an asset class,” he says. “It’s like calling a mutual fund an asset class.” Joyce worries about the huge growth in the number of hedge fund products, particularly funds of funds. “Any time an investment strategy starts to attract a lot of other entrants, I think that it takes away some of the advantage,” he says. “Funds of funds are rarely a good deal because you’re just layering on fees.” Most of the funds of funds that come knocking on his door charge a 1% to 1.5% fee, plus a 20% performance fee, on top of the underlying fund’s charge, Joyce says. But this doesn’t mean he steers clear of funds of funds completely. He’s particularly impressed with Winston Partners’ Winston Funds ( run by Marvin Bush in Tysons Corner, Virginia. Joyce used to use Winston’s international fund, but has switched to the company’s small-cap growth fund, which “has done very well.” Winston has “a much lower fee structure; the management fee is 85 basis points and the performance fee is 5%, rather than 20%,” he says. “What we’re trying to do with hedge funds is in an inefficient area capture almost all the upside, while vastly minimizing our downside.”

When considering a fund of funds, Joyce recommends that advisors always find out how much of the general partner’s money is invested in the fund. In Winston Partners’ case both partners, Marvin Bush and Scott Andrews, “have substantially all their net worth invested” in the hedge funds of funds and private equity fund, he says. And, of course, watch the fees. Another tip: Find out how you can monitor leverage. “A lot of times the people who run the hedge fund of fund can’t get the information from their underlying funds on leverage, and that makes me really nervous,” Joyce says. “But, I want to know up front that they will be telling me, at least on a quarterly basis, how much leverage that their overall fund of funds has and what [type of strategy] each one of the underlying hedge funds are using.” Advisors should also factor in the hedge fund’s tax implications because they trade very frequently.

To brush up on the latest alternative investing techniques, Joyce says he gets a copy of college endowment reports from Yale, University of Virginia or the Wharton School. “They’re very often doing innovative things, and they view their portfolio as long-term, even though there’s a distribution requirement each year,” he says.

“Almost any good-sized, well-performing endowment has an allocation to alternative investments, whether it’s private equity, VC, natural gas royalty interests, or even some are investing in structured settlements,” in which firms package structured settlements from the lump sum cash awards won by lottery winners or accident victims.

If you’re looking to jumpstart an alternative investment program for your clients, starting your homework from a college endowment report may be a good place to start. –With William Glasgall