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Portfolio > Alternative Investments > Hedge Funds

Road Less Traveled

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The world of alternative investments has become more important to a number of advisors for one simple reason–traditional investments don’t provide the desired return or the appropriate level of risk for clients. “In our April newsletter we took a look at that whole [alternative investing] spectrum, and it was really under the rubric of people reaching for higher returns, but incurring much more risk to get them,” says Gary Shilling, president of A. Gary Shilling & Co., a firm of advisors and economists based in Springfield, New Jersey. “A lot of people, after the ’90s performance, felt that their God-given right was 20% returns a year, and if stocks wouldn’t do it, there had to be something else that would.”

In a recent poll conducted at the Investment Advisor Web site, 74% of participating advisors indicated that they use some type of alternative investments for their clients. The favorite choices were real estate vehicles (23%) and funds of hedge funds (19%). Another 6% indicated that they used single-strategy hedge funds.

Real estate investment trusts (REITs) are probably the most hassle-free way for investors to play the property game, although, like many other vehicles, returns are likely to be lower in the foreseeable future. Promoters of real estate in general and REITs in particular like to point out the lack of correlation this asset class has to the overall stock market.

“REITs over the next five to seven years we expect to deliver not much more than their dividend return, but they will provide a higher return than U.S. stocks, which we expect to deliver in the low, low single-digit numbers over a similar time frame,” says Lou Stanasolovich, CEO of Legend Financial Advisors in Pittsburgh, who has been using REITs since 1986 and no longer considers them an alternative investment.

Joe Battipaglia, chief investment officer of Ryan Beck & Co., notes that his company has reduced the REIT components of its suggested asset allocation. “We’re expressing what I would call a near-term cautiousness about the group because we noticed that the yield spreads between publicly traded REITs and Treasuries had narrowed greatly coming into 2005, which meant that we were vulnerable to changes in interest rates,” he says. “So we put out our 2005 forecast that the range of returns for REITs this year could be between 0 and 10%. So while you may receive the average yield on a REIT of 5%, you may suffer principal erosion to offset it. The risk and reward did not favor the investor on a short-term basis although within the category, there are pockets that are interesting and we will continue to monitor those. We like strip mall development companies and we like some in the healthcare sector.”

These days, Battipaglia sees REITs generally as a vehicle not only for total return investors, but for the income-oriented. “I think REITs have matured enough as an industry in terms of diversity, history, and finances that now an income-oriented investor should consider REITs as part of their portfolio choices,” he says.

Single-Family Homes

A new way for accredited investors to add real estate diversification to their portfolios is through Redbrick Partners, a New York-based company that has created real estate investment partnerships that invest in single-family housing. The company has two funds in operation that own a total of 800 houses. A third closed-end limited partnership is expected to open shortly, which according to managing partner Jonas Lee, should bring the total number of houses to around 2,000.

“At a high level, what we’re trying to do is institutionalize investing in single-family housing,” he explains. Redbrick buys houses that sell in the $60,000 to $90,000 range in cities like Philadelphia, Baltimore, and Trenton and manages the properties as a landlord, with the goal being steady cash flow for the fund’s shareholders–each of whom has invested a minimum of $100,000–more than asset appreciation.

“Everyone knows someone who has a single-family rental property, but a lot of people don’t do this very well,” Lee points out. He notes that an investor might buy the house next door, not the one that’s going to give him the best cash flow, and that often he won’t factor in the management costs, including his own time and taxes, and the fluctuating vacancy rate.

“Financial advisors like us because we’re the hands-free way of playing in single-family housing,” he says. “The yield in moderate-income and working-class areas is much better than trying to buy something in Manhattan and renting it out, or a beach property in North Carolina. Those are more emotional rather than financial investments.”

Hedging Their Bets

Increasingly, investors have been turning to hedge funds to add diversity to their portfolios. Legend Financial’s Stanasolovich finds them to be a valuable weapon in the arsenal he uses for his clients, particularly in the fund of funds format.

“When you use a hedge fund of funds, you’re choosing a manager who hopefully can put together a number of hedge funds in a portfolio that makes sense and significantly reduces risk,” he explains. “Overall, we believe that run correctly, a hedge fund of funds as well other investments will deliver a superior risk-adjusted return versus stocks.

“But you also have to consider the fee structure. Even if you earn a 15% gross return, by the time you pay down all the fees, you might earn as little as 6.5% [or] as much as 9.5%.”

“There are three big problems with hedge funds,” admits Robert Schulman, CEO of Tremont Capital Management, a hedge fund company owned by Oppenheimer Funds. “They are expensive. They are not transparent. And they are not necessarily liquid–you can’t call up tomorrow and change your mind.”

“On the flip side,” he continues, “there are better risk-adjusted returns. If you invest in domestic equities, you can diversify and get small benefits from that diversification, but when the market goes down, you lose money. The diversification may cause you to lose a little less, but diversification in U.S. domestic equities doesn’t get you much. Hedge funds are real diversifiers. They really act differently than what goes into a traditional portfolio.

“The second benefit, and I’m going to speak heresy now,” warns Schulman, “is that there’s lower risk. The last time there was a disaster in the marketplace, between August and September 1998, the average equity mutual fund was down 18%, [while] the hedge fund index was down four and change. By any measure, hedge funds have less risk than a traditional equity fund.”

According to John Kelly, president and CEO of Man Investments Inc., another hedge fund distributor, there’s been a real groundswell in interest of late. “I don’t think it’s all performance driven, because hedge funds have been through a lackluster period as well,” he says. “I think it’s just a matter of understanding what a hedge fund is. What are the characteristics of this product? What’s the liquidity? What is the risk? Do I understand that by going to this I should really be looking at a three-year horizon and not be looking to trade and come out in six months’ time?”

Kelly is in agreement with advisor Stanasolovich about the best place in the hedge fund space for most individual investors. “A fund of funds is where private investors should be,” he advises. “Private investors, unless they’re very, very wealthy, shouldn’t be in individual hedge funds.”

Kelly also shares Schulman’s viewpoint that perhaps the risks have been exaggerated, at least regarding funds of funds. “There’s a lot of academic research indicating that including hedge funds in a portfolio is able to improve the risk-reward characteristics, pushing the return up a bit and pushing the volatility down a bit,” he continues.

For those looking to dip a toe into the hedge fund stream, Kelly suggests they start small. “Clearly anyone with a $1 million portfolio who puts $25,000 into hedge funds is going to be much more relaxed than an investor putting $250,000 into a hedge fund. After they’ve become familiar with the asset class, they may take their allocation up a bit, or they may say, ‘It’s not for me.’”

As Kelly points out, not every alternative investment meets the needs of every investor, and even the best of vehicles doesn’t always produce the desired result.

“We’ve seen some [alternative investments] come to grief lately, with the flattening of the yield curve, the GM disaster, and the widening spreads of Treasuries vis a vis junk bonds and emerging markets” notes economist/advisor Shilling. “Those things have been losing money for people. I think a lot of people have been straining for yield and not realizing how much additional risk they’ve been taking.”

As always, that’s where a good advisor comes in.

Staff editor Bob Keane can be reached at [email protected].


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