Despite the promise of high profit margins in a business that is growing like wildfire, why are some traditional advisory firms steering clear of alternative investments?

Some traditional firms believe that hedge funds are nothing but a fad, and that they are not established enough to be considered a legitimate investing vehicle. Others feel that overcrowding in many strategies will reduce future returns, a trend that has been in place over the last two years. Some say that enhanced regulatory scrutiny of hedge funds will make the business much more expensive, especially for the larger players.

Those risks aside, the firms that are staying out of the alternative investment industry are betting that conventional ways of investing money will continue in the future–a belief that dangerously overstates the success of active, long-only investing.

A recent study performed by Morningstar illustrates the shortcomings of conventional investing. According to the fund tracking firm, as of the end of 2004, over the three prior years nearly 30% of all large-cap funds had followed so closely the ups and downs of the S&P 500 index that they could be described as “closet indexers.” This was so even though the average expense ratio for such funds had risen to nearly 1.50% per annum. In my view, the odds of investor revolt are high.

Of course, hedge funds are far from the universal remedy many of their supporters claim. One particularly vexing problem is the high percentage of funds that shut down after a run of bad performance. Valuation issues are also troublesome. But it seems clear that if the traditional firms do not offer alpha-producing strategies to their largest clients, they run a big risk of losing them.

Index Feb-05 QTD YTD Description
S&P 500 Index* 1.89% -0.69% -0.69% Large-cap stocks
size=”-1″>DJIA* 2.63% -0.16% -0.16% Large-cap stocks
Nasdaq Comp.* -0.52% -5.69% -5.69% Large-cap tech stocks
Russell 1000 Growth 1.06% -2.31% -2.31% Large-cap growth stocks
Russell 1000 Value 3.31% 1.48% 1.48% Large-cap value stocks
Russell 2000 Growth 1.37% -3.19% -3.19% Small-cap growth stocks
Russell 2000 Value 1.99% -1.96% -1.96% Small-cap value stocks
size=”-1″>EAFE 4.34% 2.44% 2.44% Europe, Australasia & Far East Index
Lehman Aggregate -0.59% 0.03% 0.03% U.S. Government Bonds
Lehman High Yield 1.47% 1.34% 1.34% High Yield Corporate Bonds
Calyon Financial Barclay Index** 0.23% -2.41% -2.41% Managed Futures
size=”-1″>3-month Treasury Bill 0.33%
All returns are estimates as of February 28, 2005. *Return numbers do not include dividends. ** Returns are estimates as of February 24, 2005