In With the Old
Increased transparency and decreased investor qualifications are just some of the factors fueling the return to alternative investments.
By Carolyn Tang Kmet
Modern portfolio theory espouses the need to manage volatility through investment diversification. Traditionally, investors carried this out by investing in companies of various sizes. The thinking was that if large- and mid-cap stocks were down, small-cap stocks would go up. Over the past few years, however, an overall market downturn has seen increased correlation in these asset classes.
“Many years ago, diversification was typically sought through a combination of largecap, mid-cap and small-cap US equity investments, developed international equity, emerging market equity, fixed income and real estate,” explains Scott Warnock, cofounder of financial advisory team Aspinwall Executive Consulting. “Unfortunately, with the exception of fixed income, all of those asset classes had five-year correlations to the large-cap US stock market north of 75 percent.”
In other words, portfolio diversification through traditional assets was no longer working. Investors were no longer experiencing a narrow, managed range of return outcomes, and instead were exposed to the very volatility they were looking to avoid.
“It was at this time that the majority of investment professionals realized that the old meat-and-potatoes asset classes such as stocks, bonds and real estate were too closely correlated with one another to provide meaningful benefits of diversification,” says Alexey Bulankov, CFP, with McCarthy Asset Management. “Like a couple that have been married a long time, they start to resemble each other too much in many respects.”
As a result of this increased volatility within traditional portfolios, alternative investments made their way from the margins to the mainstream. “From 2002 to 2007, it was relatively easy to raise money from investors and performance was good,” recalls Ronen Schwartzman, founder and CEO of Ten Capital Advisors LLC. Back then, he says, the number of hedge funds reached as high as 10,000.
And then, in 2008, everything plummeted. The hedge fund industry had its worst performance year, with the HFRI (Hedge Fund Research Indices) index losing 19 percent. “Many hedge funds lost money and therefore failed to provide hedges or absolute returns to their clients,” Schwartzman explains. “Fraud events such as Madoff and Stanford, as well as the managers that gated their funds and prevented redemptions or side-pocketed investments, didn’t help the overall alternative space, and as a result many hedge funds were closed.”
Today, however, investor interest in alternative investments (hedge funds, venture capital, commodities, managed futures, currencies and even wine) is again on the rise.
John T. Hague is a partner with McGladrey and Pullen LLP. He is also the firm’s national director of the Alternative Investments and Brokerage Group. He says that alternative investments often provide investors with access to new or different markets, strategies and investment types, diversification of investments to manage market risks, higher returns, reduced volatility and geographic expansion. “The markets have been quite choppy and unpredictable recently, and investors are seeking stable returns with lower market risks,” he explains.
“I think what’s driving this evolution is a desire to find something newer and better than traditional stocks, bonds, CDs and traded REITs,” remarks Adam Koos, CFP, founder and president of Libertas Wealth Management Group. “Investors are sick of making and losing their hard-earned money. In the face of what could turn into a brand new recession, they want safety in diversification and yield, and something that doesn’t correlate with the traditional investments they already own.”
Schwartzman describes a recent trend: Investing in smaller, emerging managers. “The prop desks at the large banks trained some of the best hedge fund managers,” he explains. “Now that the banks are closing their prop desks as they are not allowed to trade any longer, more talented investors are leaving to start their own funds, and some will join existing hedge funds.”
Schwartzman also believes these emerging managers are being lured into the alternative investment market by attractive 2-percent management fees and 20-percent performance fees. (He notes that these numbers are general; some managers charge more while others charge less.)
Demand for alternative investments certainly is growing, “We’ve started to see more retail alternative investment products hit the market in the form of mutual funds and ETFs,” says Koos. He notes that the downside to this, however, is the ease with which less sophisticated investors can enter the market. Traditionally, alternative investments were only accessible to high net-worth individuals and institutional investors with large sums of money due to minimum capital contribution requirements and government regulations. Since minimum requirements have dropped, investors who have $250,000 liquid net worth can now enter the arena.
Additionally, different types of institutional investor are going the alternative route. “Endowments, foundations, trusts and not-for-profit organizations have either entered or increased their investment allocations,” Hague points out. “Once taboo for these entities, there’s a perception that the industry is now professionally managed, regulated and socially acceptable.”
Furthermore, increased transparency in the alternative investment industry has paved the way for increased investment dollars. Several years ago investment advisors tended not to display or disclose their propriety trading strategies. “However, increased regulatory scrutiny, the onset of more competition and the desire to raise investment capital has led to more transparency than ever before,” Warnock reports. “Many managers, who in the past operated as a ‘black box,’ providing no insight into the portfolio’s make-up, are now providing many more details to potential investors, and due diligence teams are reviewing their strategies for new investments.”
Transparency is certainly a key factor for investors exercising their fiduciary duties, and as most alternative asset managers are enhancing their reporting and valuation processes, documents such as the International Private Equity and Venture Capital (IPEV) Valuation Guidelines are on the rise.
“For example, best practice is evolving for alternative asset managers to use an experienced third-party valuation expert to validate valuation estimates and thereby enhance transparency to investors,” says David Larsen, managing director in the Alternative Asset Advisory practice of Duff & Phelps, and a resident in the firm’s San Francisco office.
Warnock adds that the institutionalization of alternative managers has driven transparency even further. “Many alternative investment managers now have extremely well-developed back offices, risk management personnel, compliance departments and more,” he explains. As a result, communication with investors has increased, and advisors and due diligence officers have better access to portfolio managers than ever before.
“Certainly, the combination of more product offerings, fee compression, lower investor qualifications, the institutionalization of alternative managers and more transparency should lead to growth of the broader alternative investment industry,” Warnock comments.
However, David Nanigian, PhD, an assistant professor of investments at The American College in Bryn Mawr, Pa., feels it’s difficult to determine transparency’s ultimate impact on the growth of the alternative investment market. “On the one hand, an increase in transparency may positively impact growth due to the alleviation of informational asymmetries regarding diversification of portfolio holdings and the funds’ selectivity in capital allocation,” he states.
“On the other hand, it may negatively impact growth due to ‘copycatting’ amongst individual investors.”
Schwartzman understands the need for transparency, but says it should be taken in context. “If a long/short equity manager is invested in 60 different securities, I don’t need to know all of them; I care about his top 5 or 10 positions—the ones that drive the performance for the fund.”
Schwartzman also points out that if you have enough capital, then having a separately managed account “gives you 100-percent transparency and the ability to fire the manager whenever you want.”
Warnock warns that while many good products will be created, there are many others that are sure to miss the mark. Further, alternative investments tend to be illiquid, which will cause some investors to shy away. “Liquidity is a major concern with alternatives, so investors need to ensure that the liquidity features of a specific product matches their needs,” says Warnock.
On top of that, “Many investors had nasty surprises in the financial crisis when many funds exercised their rather esoteric authority to suspend redemption requests or only partially honor them,” says Dr. Nanigian.
In light of such outcomes, Nanigian urges investors to exercise due diligence when considering alternative investments. “You should bear in mind that the high reported average returns should be taken with a grain of salt due to voluntary reporting standards,” he says.
Warnock boils it down: “Alternative investments present an opportunity for investors to diversify out of traditional equity holdings. However, investors must be careful to understand what they are selecting as alternative exposure in portfolios ensure the product provides the benefits common among alternative investments, and is not another traditional offering in disguise.”