December 20, 2011

Alternative Solutions for Advisors

By Thomas J. Barrett, CFA, CFP, CPA and Marc Grens

Beyond prevailing economic and market conditions, asset allocation is the most important factor

affecting the investment returns of multi-asset portfolios. Studies have found that over 90% of the

return variations between portfolios can be attributed to the allocation process, demonstrating the

crucial importance of selecting the proper blend of assets versus the specific investment vehicles.

Typically, managers have used modern portfolio theory and scenario analysis to determine the ideal

asset allocation (the efficient frontier) for their portfolios given the returns, risks, and correlations of

the assets under consideration.

However, there are now some concerns with using modern portfolio theory to build portfolios. The

ideal asset allocations, constructed to generate the optimal risk-adjusted returns, disappointed

investors during the bear markets of the past decade (particularly 2008). During those market

corrections, the correlations between asset classes increased dramatically. Traditional asset allocations

did not provide the protection against falling prices that investors had expected.0

To protect against highly-correlated bear markets, client portfolios should include hedge fund exposure

to deliver diversification, increase returns, and reduce volatility. The specific advantages of hedge

funds include: absolute returns in up and down markets, low correlations to other asset classes,

unconstrained investment strategies, capital preservation, and incentivized manager compensation.

Unfortunately, there are compromises with hedge funds, including: higher management and incentive

fees, lower liquidity, tax inefficiencies, limited transparency, non-normal (fat-tail) distributions and less

regulatory protection. Overall, the increased returns, lower volatility and diversification positives of

hedge funds outweigh the obvious negatives.

The suggested way to incorporate hedge funds into a portfolio is through the implementation of a

three basket approach identified as: core, satellite and overlay. The core basket would normally get the

major allocation and primarily focus on capturing beta (market returns) by investing in traditional

stocks, bonds, funds, indices and ETF’s. The satellite basket would focus on capturing alpha (excess

returns) by investing with higher performing managers and hedge funds. The overlay basket would be

utilized to make tactical bets in response to changing market conditions. Overlay strategies can utilize

leverage, ETF’s and derivatives to reposition a portfolio’s overall market exposure. The basket

allocations would be determined by assessing the risk profiles of individual clients.

Hedge funds come in many varieties and managers usually focus on specific niches in the market. Fund

returns are driven by market opportunities, security spreads and volatility plays. There are numerous

hedging strategies available in the market, but there are a dozen primary strategies. Event driven

strategies include convertible bond arbitrage, merger arbitrage, distressed securities and opportunistic

equity. Discretionary strategies include long/short equity, short biased and global macro. Other unique

strategies include equity market neutral, managed futures, emerging markets, risk arbitrage and fixed

income arbitrage. Selecting between the different strategies can be a challenging assignment for most

investment managers. In the same way diversifying a portfolio with hedge funds is beneficial;

diversifying among different strategies can be extremely valuable.

The benefits of hedge funds can be further enhanced by investing in emerging and boutique funds.

Early stage hedge fund investing can be more profitable than investing in older, larger established

funds, but requires more due diligence and manager monitoring. Investors that want the higher

returns of early stage funds would benefit from hiring an experienced hedge fund consultant or

investing with a fund of hedge funds (FoF). A FoF can invest in a portfolio of funds to provide broad

exposure to multiple strategies while reducing the risks associated with individual funds. The FoF’s

select underlying managers, perform due diligence, construct diversified portfolios, manage overall

risks and provide access to elite funds. The benefits of funds of hedge funds come with some trade-

offs, including an additional layer of costs, a short-range market focus, and generic investment

solutions.

In recent years Wall Street, quick to seize upon a trend, has launched retail products to meet the

demand for alternative investments. Mutual funds and Exchange-Traded Notes (ETN’s) have been

created to give investors exposure to alternative assets. These alternative products focus on retail

clients, carry significant fees, and produce disappointing returns (in comparison to quality hedge

funds). By offering daily pricing and liquidity, the products sacrifice the excess returns associated with

unique, longer-term and less liquid strategies. Hedge fund managers need time for their strategies to

develop; daily liquidity requirements generate a return drag and distract managers from their

strategies.

The best in breed investment advisors, on the forefront of portfolio construction, are beginning to

provide turn-key multi-manager hedge fund offerings. By utilizing innovative structures, alternative

asset portfolios can be tailored to an advisor’s specific clientele. If you accept the proposition that

hedge funds are a key element of an efficient portfolio, accessing superior funds through a turn-key

solution could be an essential step in the asset allocation process. (One benefit of the turn-key model

is that through client aggregation advisors gain leverage to negotiate better capacity, fee and liquidity

terms from hedge fund managers.) Since most advisors do not have the resources or expertise to build

a high-quality collection of hedge funds, outsourcing those efforts to a firm with institutional

knowledge of alternative assets would be a win-win solution for everyone.

Whether an investor invests in hedge funds directly, through a fund of funds or a customized solution,

it is highly advisable to include alternatives in the portfolio to provide broad diversification, increase

expected returns, and reduce overall volatility.

Tom Barrett is the Chief Investment Officer of Alpha Strategies Investment Management and Marc

Grens is a Managing Director at the firm.