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What Alternatives Do Advisors Have?

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For the second consecutive year, Morningstar and Research have surveyed advisors nationwide on their perception of and experience with alternative investments.

[Note: Charts appear at end of article.]

Our September survey found that:o the growth rate in alternative AUM in the last five years has slightly moderated o the growth rate in alternative AUM anticipated for the next five years is also lowero the alternative products that have driven increases in the recent past and which are expected to drive growth in the near future have changed in the past yearo 130/30 products, which Morningstar identifies as “leveraged net long” investment strategies, have not yet had much impact on non-institutional investors.

It bears noting that the timing of our survey coincided with the meltdown in subprime mortgages. The resulting headlines seem to have had a tangible influence on the opinions and outlook of financial advisors as regards hedge funds, private equity activity and other investment alternatives.

Of the statistically significant 717 respondents to our Internet-based survey (sent to readers of Research and advisors who are customers of Morningstar), the typical respondent was an advisor affiliated with an independent broker-dealer or an RIA, with 100 to 200 clients, under $500,000 in gross production/income and under $100 million in AUM. This profile is important to keep in mind in reviewing the results that follow.

We expanded the definition of alternative investments in the 2007 survey to now include art, infrastructure, natural resources, precious metals and weather derivatives.

Advisors agreed with the investments we added to the list. The highest level of agreement by advisors on which products to define as “alternative” was for hedge funds — 93 percent agreed with including them. The sibling poster child of non-traditional investing is private equity, as 92 percent of advisors agree that it is indeed “alternative.”

Advisors also gave their input on what they consider alternative and there were numerous mentions of collectibles, long/short funds, managed futures, oil and gas investment vehicles, and REITs — both public and private.

In 2007, 83 percent of advisors have at least some of their clients invested in alternatives. A plurality of advisors, 38 percent, have 1 percent to 10 percent of their clientele using alternatives; 17 percent of advisors report 11 percent to 25 percent of their clients are invested in alternatives. An impressive 12 percent of advisors indicate that over three-quarters to all of their clients are using alternatives. (See Chart 1.)

A high percentage of portfolios, 77 percent in 2007, have less than 10 percent of their assets allocated to alternatives. But 12 percent of advisors have allocated as much as 11 percent to 15 percent on average of their clients’ portfolios to these types of holdings. (See Chart 2.)

Looking back over the last five years, however, 41 percent now estimate that they have experienced double-digit growth in alternative AUM every year for the past five years. In 2006, 57 percent of advisors reported such a strong average yearly growth rate. Significantly fewer advisors have been experiencing strong growth from alternatives in 2007. (See Chart 3.)

A moderation in growth is also apparent when we asked advisors to look ahead. In 2006, 65 percent of advisors expected double-digit growth in alternative AUM every year for the next five years. This year, only 44 percent of advisors are that optimistic their business will grow accordingly. The majority of advisors, 56 percent, only expect growth rates varying between 1 percent and 10 percent every year for the next five years. A full 21 percent more advisors than in 2006 expect this slower rate of increase; last year only 35 percent were expecting such modest annual growth rates. (See Chart 4.)

We examined the results for expected growth rates by the different “demographic” groups in the survey. Regardless of practice type or number of clients, the lowered expectations were remarkably similar.

In a similar vein, perhaps more realistically than last year, a full 67 percent expect alternative investments to become less important relative to the traditional investment choices of stocks, bonds, mutual funds, etc. over the next five years. That’s 15 percent more advisors with a diminished outlook over 2006. And of that 67 percent, 33 percent think alternatives will be “much less important,” not just “somewhat less important.” (See Charts 5 and 6.)

Last year, lack of understanding was the No. 1 reason clients and advisors hesitated to invest in alternatives, followed by lack of liquidity, and then fees. In 2007, lack of liquidity is the No. 1 deterrent, followed by lack of understanding, and then lack of transparency.

Again, for all of the above survey results, the daily headlines throughout August of stock market decreases and the freezing of some areas of the bond market, and the liquidity interventions of the Federal Reserve and the European Central Bank would seem to have affected financial advisors and their clients.

There has also been a dramatic change in the alternative investments that have provided growth in the last five years. In 2006, the most growth (for over 30 percent of advisors) had come from real estate. In 2007, real estate as the major growth driver has diminished to 18 percent of advisors. Commodities were in second place in 2006. In 2007, commodities have fallen to sixth place, with only 7 percent of advisors indicating this asset type has provided the greatest contribution to their business since 2002. (See Chart 7.)

Most surprising, “other” alternatives than the ones we surveyed for were listed by advisors as giving the most increase to their business in the past five years. Specifically, alternative investment strategies available through mutual funds and ETFs, managed futures, public and private REITs, and separate accounts were mentioned most often by advisors as having driven their alternative business volume.

Influenced by the types of clients they are serving, advisors have shifted rapidly between 2002 and 2007 into alternatives encompassed in familiar, liquid, traded, regulated and transparent investment vehicles. Apparently, the investment vehicles used to access alternatives are as important a consideration as the investment strategy or asset class being accessed.

It follows that advisors responded that 60 percent of their clients are accessing alternative asset classes and investment strategies through mutual funds, followed by 46 percent using ETFs. Direct investment was the third highest means indicated, at 42 percent. Clients of the advisors that responded use hedge funds of funds, hedge funds, and separate accounts far less often: 26 percent, 21 percent, and 18 percent respectively.

Now, it seems, this trend of accessing alternatives packaged in traditional products looks set to continue. In 2006, 28 percent of advisors thought capital-structured products would drive the growth in alternatives over the next five years. (See Chart 8.) Now, only 13 percent of advisors think this will be the case. The difference is not great, but 16 percent think “other” investment vehicles will set the pace, 15 percent are expecting it will be direct real estate, and 14 percent perceive hedge funds as driving growth. (See Chart 9.)

While advisors downgraded their expectations for real estate and hedge funds as growth drivers from the 2006 survey, in one year the percentage thinking private equity will drive alternative investing more than doubled, from 5.5 percent in 2006 to 12 percent in 2007.

And the “other” investment vehicles expected to appeal to investors are many alternatives packaged in traditional clothing: mutual funds and ETFs investing in natural resources, infrastructure, currencies, or pursuing absolute return and market-neutral strategies. Futures, including managed futures, were noted by a number of advisors, with fixed annuities, master limited partnerships and private REITs being predicted by a smaller but significant number of advisors.

We delved into this shift in results in the survey and asked advisors why they chose to invest in alternatives indirectly, through traditional investment vehicles. The answers are not surprising, but are still illustrative and insightful:o Access to desirable investment strategies but with proven managers and liquidityo Accessibility and liquidityo Assume a layer of expertise in between the investor and the product as well as increased liquidityo Convenienceo Cost-effective o Diversification and lower costs versus direct investmento Diversification in the hands of managers with experience and an investment track recordo Easier to understando Familiarity with product structureo Liquidity, liquidity, liquidityo Liquidity, tax issues and accredited investor requirements.o Low correlation with core portfolio investments in stocks and bonds; transparency; liquidity; reasonable fees; ease of benchmarking returns; offerings from high quality investment organizationso Non-correlating asset, absolute returnso On a deal-by-deal basis, the best opportunity in the space at the timeo Putting another party in the loop assuming some responsible review process is being renderedo We are only investing directlyo We don’t have the expertise/resources to invest directlyo When I trust the separate account manager and they have an audited track record of strong performance, I let them make these decisions

If there has been a constant, the investment objectives for putting client dollars into alternatives have largely remained the same in 2007 and 2006: a) to address and lower correlation amongst the investments in a portfolio, b) achieve absolute returns, and/or c) fill allocations to areas of the market where the client may not previously have been adequately exposed. (See Chart 10.)

We strive to make the Morningstar/Research survey attuned to current events in alternatives. In 2006 we asked about SEC regulation of hedge funds. In 2007, we turned to the intense development effort by money management firms to roll out 130/30 strategies, which Morningstar calls “leveraged net long” investment approaches (and others term “dynamic” or “short-extension” strategies).

In any case, 130/30 and its numerous cousins and offshoots of 120/20, 140/40 and other ratios are definitely still a Wall Street, not Main Street interest. Fully 80 percent of advisors responded they were not enthusiastic about the potential performance of leveraged net long products. Eighty-two percent have no clients who have asked about 130/30 and of the remaining 18 percent of advisors, the percentage of inquiries come from less than 10 percent of their clientele. Ninety-eight percent have 20 or fewer clients invested in 130/30, not surprising at this very early stage of mutual fund roll-out. Skepticism is the prevailing impression of the open-ended opinions we asked advisors to provide:o “Another product that is being sold”o “Fees, too much research, client discomfort”o “It’s still stock picking, and getting the short sales right is even harder than the longs.”o “More intrigued at this point than enthusiastic”o “Leverage is leverage no matter how it is packaged. The risk of margin calls is still there.”

If there are any conclusions to be drawn from the survey overall, it appears that advisors and their clients are comfortably, steadily and realistically adopting alternatives. Expectations have moderated. Alternatives are not a panacea for all investment ills, but a logical portion of many clients’ investments. Despite recent events and while more leery of alternatives, advisors and their clients are not in any way abandoning these choices. The downside of direct investment in unregistered investments and investment vehicles is understood, there are known unknowns (such as lack of transparency and questionable valuation), and there are traditional means to the approximate same end it seems in the form of managed futures, mutual funds and ETFs.

Steve Deutsch, CFA, CAIA, is Morningstar’s director of separate accounts.