Despite the recent tumult in the hedge fund world with the collapse of Bear Stearns’s two hedge funds and the subsequent arrest of its two managers a month ago, money continues to pour into hedge funds. According to PerTrac Financial Solutions’s 2007 Hedge Fund Database Study, assets under management by single-manager funds topped $2 trillion last year and $980 billion flowed through funds of hedge funds.

Indeed, the current global credit and liquidity crises, along with low bond yields and economic instability, are forcing more and more advisors to turn to all sorts of alternative investments to diversify their clients’ portfolios and find uncorrelated assets, says Doug Beck, managing director and head of product management at DWS Investments, formerly DWS Scudder. Mutual funds that use hedging strategies are increasingly in vogue as well. DWS started its DWS Alternative Asset Allocation Plus Fund in July 2007, and the fund has accumulated a whopping $400 million in assets in less than a year.

I spoke with Beck in late June about the use of alternative investments.

Can you elaborate on how the current market is fueling the use of alternatives? We’re definitely talking about alternatives broadly cast, so strategies that have low correlation to the traditional asset classes that are the building blocks of portfolios like U.S. large-cap equities and investment-grade fixed income and the like. So satellite strategies that have lower correlations also include international equities but going out further on the fringe, emerging markets, emerging markets debt, and even further out into commodities, precious metals, inflation-protected securities, and, finally, last but not least, hedge-type strategies like market neutral funds. So the bottom line of what those all have in common, as I started with international equities and expanded out to market-neutral products, is they have increasingly lower correlation to the building blocks of what would be a typical asset allocation.

The current environment has exacerbated that and made the challenge even more of an imperative given the fact that when you get into crisis-type situations, not just the current but crises of the past, your correlations for the most liquid asset classes tend to spike up for periods of time. That doesn’t just mean that U.S. large cap S&P 500, for example, relative to let’s say European markets, but it also means, in some instances, equities relative to fixed income, which you would typically not expect.

How are inflation worries affecting the use of alternatives? That’s occurring now, correct? Yes. This crisis is different in and of itself in that initially we had a credit issue that sparked a liquidity crisis and simultaneous to that we have a spike in commodities and that’s fueling certain inflationary fires. Basically what’s unique is that we’ve been in a period for almost the past 25 years up until very recently where it made sense to trade out of real assets for paper assets. Now, what I’d say is instead of real for paper, we’re now potentially going back to paper for real to some degree.

Explain. Paper assets being traditional equities, traditional fixed income. Commodities have not been in vogue until quite recently, and that’s been because we’ve been in a deflationary environment. People forget about the time where you had, up through the late 1970s, a President on television wearing a cardigan sweater saying everybody should wear an extra sweater and lower the heat in their house. Then we entered the ’80s, ’90s, and early 2000s where inflation was kept under control, there was a lot of outsourcing of labor, commodities were still plentiful, and now we’ve had several different triggers–emerging market growth is shooting up, China, India–and labor isn’t as cheap anymore. We have everything from climate change impacting rainfall in Chile so the Chilean copper mines that are driven by hydroelectric power don’t have power. You have dislocation in a lot of these commodities markets, and that’s fueling a reallocation from institutions and individual investors, many of whom, until recently, didn’t have any significant allocation to what we call real assets, or real assets in their portfolios or equities that benefit from real asset price inflation.

When talking about devoting a certain portion of a client’s portfolio to alternatives, is there a standard allocation that you recommend? It certainly depends on the client’s risk tolerance and time horizon. We don’t make the recommendation. The financial advisor is in control of that, but I think what’s important as it pertains to our Alternative Asset Allocation Plus Fund is that this is a combination of satellite asset classes as well as more sophisticated hedge-type strategies like a market-neutral portion of the portfolio. So when you’re looking at allocating to inflation-protected bonds, for instance, that are very high quality and give you an inflation hedge, or even emerging market equities which have become more mainstream of late–and emerging market debt–for some investors that’s already been a conscious allocation in their portfolio. When you start getting into market neutral, which is a relatively new strategy for retail investors to embrace–and some have not even started to embrace–that tends to be a smaller allocation of what most advisors would suggest in an individual’s portfolio. Having said that, the starting point from what we’ve seen tends to be a low of 5% into alternative strategies, and if someone has a very long-term time horizon and is willing to take greater risk and volatility in their portfolio, as high as 20%.

Some hedge fund strategies that have been embraced by institutional investors are now coming to retail, correct? Some of them are. An important point to make is that some people view hedge fund strategies as [being on] a different planet that’s been discovered. We’re still all grounded on earth here basically and these are different ways to construct portfolios–still investing in the same financial assets or securities that traditional managers have been doing for decades–equities, fixed income, different derivatives instruments. What the hedge fund growth has been fueled by is fewer constraints on tracking of a benchmark, and other hedge fund strategies have also been fueled by adding leverage to their portfolio. We’re not basically levering up our portfolios here, the [DWS Scudder Alternative Asset Allocation Plus Fund] is a 1940 Act mutual fund with very constrained amounts of financial leverage when they utilize it at all.

What’s the outlook for the hedge fund industry going forward? Any investor needs to go into any strategy with eyes wide open. The history of financial products has not been 100% success; there’s no guarantee outside of bank deposits and any strategy that embraces additional return requires some sort of implicit risk. There’s no free lunch, and any investor that goes into any strategy needs to understand exactly what they are buying.

Explain the DWS Alternative Asset Allocation Fund’s strategy. It’s a mutual fund and a fund of funds at the same time. It’s based on seven different underlying funds as components with a tactical asset allocation overlay–what’s called portable alpha. So essentially you have eight strategies with automatic asset allocation and rebalancing and eight different portfolio teams or team of managers underlying in one portfolio. [That includes] all of the regulatory oversight that’s required and all of the transparency of a 1940 Act fund, daily liquidity, etc.

These mutual fund strategies have become popular in the last couple years, correct? The first type of asset allocation fund goes way back, but one can view this as an evolution of an asset allocation fund. Instead of, for instance, 60% equities and 40% fixed income all investment grade, this [DWS fund] is an assembly of eight different strategies but it still has an asset allocation to it. To your point, there are very few competitors who’ve embraced pulling all of these satellite and alternative strategies into one portfolio. With this environment, this is a timeless approach; the challenge for investors investing in these eight additional asset classes that might make up only 10% of their portfolio, so basically 1% per strategy would get them to their 10% allocation–there would be a lot of work and effort and ongoing diligence required for the financial advisor as well as for the investor to maintain this; the energy is better placed looking over the entire portfolio and allocating to one manager to do all the homework on these eight strategies.

What else should advisors consider when using alternatives? Regardless of whether we sail through this crisis over the next couple weeks, months, or years, the trend towards diversification and seeking better returns while mitigating risk is here to stay. You’re going to need to embrace different strategies and different asset classes and doing so in a comprehensive portfolio context or asset allocation is a requirement for successful investing here and into the predictable future.

Washington Bureau Chief Melanie Waddell can be reached at