RIAs and their high-net-worth clients have dramatically increased the use of alternative investments in their portfolios in recent years, and are on track to continue this trend. These investors are looking for better returns than they have received through traditional investments, as well as diversification and a host of other benefits alternatives can provide.
However, not all advisors, much less their clients, are comfortable with alternatives. Their concerns range from legitimate ones about risk to received wisdom about their supposedly inherent dangers.
But RIAs are increasing their use of alternative investments, particularly for the sophisticated high-net-worth client. Future articles will look at ways to access various alternative investments and the precautions necessary to protect investors.
To begin, let's assess the use of alternatives within the advisor community. A recent survey of RIAs by Rydex AdvisorBenchmarking, Inc. found that they have increased their use of alternative investments (hedge funds, private equity, real estate, commodities, currencies, and managed futures) over the past five years. According to Rydex, most advisors (42%) have moderately increased their use of alternatives (from zero to a 25% increase) in the past five years, while 24% increased their use of alternatives by more than 100%.
Advisors use alternatives, the survey found, to sample different investment techniques, to get absolute returns, to fill portfolio allocations, and to address portfolio correlation issues. A majority of respondents said they would increase their use of alternatives by up to 25% over the next five years; 13% said they would do so by more than 75%.
That's the RIA approach in aggregate, but what about individual advisory firms? New York-based Lenox Asset Management Group, for one, has experienced an increased demand by its clients for alternative investments. Michael Kuziw, a VP at Lenox, says that a big reason for this is education. His firm's high-net-worth clientele have seen their college endowments, pension plans, and the boards of private endowments on which they serve increase their exposure to alternatives, whetting their appetites while giving them comfort that they are making a good investment decision.
Kuziw and others point to Yale University's endowment as a leader among institutional investors in the move to alternative investments. According to Don DeWaay, principal of his own firm in West Des Moines, Iowa, Yale put just 20% of its portfolio in domestic marketable securities, and the remaining 80% in overseas or alternative investments. "They have access to these things and an understanding of them," he says.
So what are the advantages of using alternative investments in clients' portfolios? Ed Egilinsky, managing director of alternative investments at Rydex, points to three specific advantages. One is that alternatives, including REITs, hedge funds, and private equity, do not have a direct relationship to traditional investments. Managed futures, for example, have zero correlation to the overall market. Hedge funds may have some correlation, depending on the strategy a fund employs, but this still tends to be low. In addition, alternatives provide exposure to areas outside the long-only space, such as currencies. Finally, alternatives complement a traditional portfolio particularly in reducing the overall risk of that portfolio. Over time this benefit increases, as alternatives inherently have a low correlation to stocks and bonds.
DeWaay points out that institutions like Yale that use alternatives are very successful because they look at market inefficiencies. Alternatives, he says, represent the road less traveled, where one isn't competing against millions of others who are buying stocks in the most efficient market in the world, and for most of whom success is a matter of luck or swimming with the tide–until there's a downturn.
It is precisely the inefficiencies in everything from real estate to oil and gas and the specialized knowledge and experience these types of investments engender that make them attractive, DeWaay says. "You can go in and buy at very low cost; some are almost arbitrage situations, i.e., taking things out of an inefficient market and putting them into an efficient market–that's what private equity is all about."
In all cases, says DeWaay, the investor is trying to get close to people who have the integrity, the resources, the knowledge and experience, and the track record that suggest they really know what they're doing and have the right connections to get into spaces that provide a much higher degree of diversification in a portfolio than marketable securities do, and ultimately better fundamental valuation. "You're buying these things with a much higher profit potential."
This doesn't necessarily suggest higher risk; in fact, incorporating these types of investments in a portfolio can not only provide a chance to profit much more substantially, but also drop the aggregate risk. DeWaay says that when the markets went down substantially in 2000–2002, his firm, which uses a wide variety of alternatives, took off even as others suffered. Throughout the 1990s, he says, alternatives had been a hard sell.
Reducing Volatility
Chris Dardamon at Brightworth Private Wealth Counsel in Atlanta says alternative investments serve to build parts of a portfolio that aren't correlated with the beta market. The objective in the alternatives space, he says, is to create market-like returns with lower volatility that go up when the market goes down, providing some downside protection. A healthy allocation to nontraditional strategies is a "good all-weather piece of portfolio" that does well for investors–even in up markets. But during downdrifts, it provides great peace of mind.
Put another way: "I trust alternatives a lot more than I trust the stock market," says Gene Balliett, of Balliett Financial Services in Winter Park, Florida, who favors private equity. "The stock market is wildly emotional, and elements of it are rigged, like technical floor trading. I think a well-run private business is far more secure as an investment than money in the stock market–speaking in general terms."
Investors expect a hedge fund portfolio or a fund of hedge funds to provide absolute returns and protection on the downside, says Hilary Till, principal of a proprietary trading firm in the Chicago area. In contrast, investors expect a traditional portfolio, which contains a combination of different asset classes, to limit downside risk through diversification.
