Why you shouldn't always be giving clients what they want

November 12, 2009 — 4:28 AM UTC by Robert A. Isbitts, Guest Columnist

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Editor’s note: The pervasive know-it-all thinking today about investing is that financial advisors are irresponsible if they use market timing and brain dead if they buy and hold stocks. Those beliefs suggest that an advisor has an imperative to make more intensive use “alternative investments.” For many advisors, this category of investments does not exactly seem like a port in a storm. I asked Rob Isbitts if he could help advisors who have been boxed into this intellectual corner and “The10 alternatives to alternative investments” is its result. – Brooke Southall

Talk of “alternative investments” as a way to cope with risk is everywhere … now that the market crash of 2008 has already occurred! It is the nature of our industry to create the products that our clients want, when they want it. But that’s not actually what you should be doing.

You see, by the time the RIA’s clients decide they want something, those clients are probably reacting to the most recent movements in the markets. Your job is to do for them what they can’t do for themselves, since you, not they, are the professional advisor. That typically requires you to be proactive, not reactive, to find solutions to their problems.

Consider this: In the first eight months of 2009, 90% of the money that went into mutual funds went into bond funds. The 10% that went into equity funds was largely into the more conservative equity styles. To combat investors’ current skittishness, the industry is now obsessed with “alternative investments.” Barely on the map a decade ago, these alternative investment surround RIAs now.

Not only is the number of new products exploding: Some of the products themselves have exploded, too.

Blessing and curse

Your challenge is to function in an open architecture environment, but deal with both the blessing and curse that comes with it. The blessing is the vast array of alternative products you can now choose from. The curse is the difficulty of selecting which ones to use.

Your challenge is to select the products by analyzing several and determining which ones you think are built for success, blend them together, and have the confidence that you have done right by your client. Not to mention that you need to be sure they won’t implode at a moment’s notice, because of their internal wiring: Do they use excessive leverage, funky derivatives, etc.?

On one hand, the choices can be paralyzing. On the other, the temptation to try something exotic to prove “value-add” to your clients may be great. Many RIAs have used hedge funds of funds, managed futures and single strategy funds (hedge and mutual alike). Did they do this simply so they could check off the “alternatives” box without accomplishing much other than to expose clients to high fees or a different type of risk, one they did not truly understand?

Some alternative investments have gotten so “hot” in the RIA marketplace that they are starting to take on characteristics of the investment-product “bubbles” of the past. For instance, after a period of explosive growth, hedge funds-of-funds seem to be losing their popularity. In the meantime, product creators are one-upping each other, creating leveraged ETFs that to some of us simply look like gambling tools designed to avoid taking out a margin loan.

Commodity funds and ETFs are everywhere, and new ones are born every month. Distressed debt is the latest target, with everyone and their brother seemingly positioned to capture huge gains by raising capital to buy deeply discounted real estate and loan portfolios.

Why the frenzy?

You have to ask yourself: Why the frenzy to pursue alternative investments? As I often say to the RIAs that own the mutual fund and separate account strategies I oversee, we all know that our job is to do what is prudent. However, it is also important to do what is necessary, and not overdo it.

Lately, I see signs that RIAs are being tempted to go beyond what is necessary to pursue the objective of adding low correlation alternative investments to their client portfolios.

It seems appropriate at this point to ask, “alternatives to what?” We all know now that for investors, this decade has been strikingly different from the 1980s and 90s. This came as a shock to many RIAs and their clients, since most of them grew up in those roles during a period of consistently strong and resilient returns in stocks and bonds. Today…not so much.

This gradually created a desire for investments that could either dampen volatility or provide positive returns in mixed or even down markets. Given the potential for continued choppiness in stocks and the specter of rising interest rates for bonds (which can lead to negative returns), the demand is understandable. But must advisors delve into the world of hedge LPs, managed futures funds, private equity and the like?

Do investors need to say goodbye to daily liquidity in order to say hello to low-correlation returns? I believe the answer is a resounding no.

I have been researching and allocating among alternative investment styles using mutual funds (and more recently, some ETFs as well) for about 12 years. I am convinced that you can use the most foolproof investment vehicle I know – the open-end mutual fund – to accomplish what you want for your clients. These styles can be a complement to traditional portfolios, or can be the core themselves.

Alternatives to alternatives

To me and a rapidly growing number of RIAs and their clients, these are “the alternatives to alternatives.”

Here is my Top 10 list of such styles (in no particular order), all of which are available in open-end mutual fund form:

1. Long-Short The original form of hedge fund investment. While the hedge fund industry has done much to obscure that proud history, the approach of buying what you like and shorting what you don’t like is pretty logical. While there are similarities in style to hedge funds, Long-Short mutual funds do not use as much leverage (that level is capped by law), keep costs reasonable and are very often more tax-efficient than hedge funds. They also offer daily liquidity.

2. Market-Neutral Think long-short, but with an emphasis on keeping the longs and shorts close to even. This puts the emphasis on stock selection by the manager. Unlike the hedge fund version of this strategy, excessive leverage is not part of the plan. That’s a good thing, I think.

3. Arbitrage When handled prudently, arbitrage is a wonderful thing. One gets the opportunity for consistent upside, but with built-in protection, since most deals a fund participates in involve both a long and short position (i.e. playing both sides of a merger event). I particularly like owning merger arbitrage in mutual fund form, as opposed to the highly-leveraged hedge fund peers. This is a true hedge fund-like style, but in our preferred wrapper – an open end mutual fund.

4. Convertible mutual funds Convertibles, if chosen well, can provide the upside potential of the underlying stock, but with the “safety net” of a bond … since it is a bond until such time as it converts to the stock. The bond may carry an interest rate (“coupon”) or a company may issue a zero-coupon bond instead. Convertibles on their own are, in our judgment, the classic definition of a hybrid investment – is it a bond or a stock? Based on the potential outcomes of a convertible issue, we’d say the answer is “yes!” It is both. In bull markets, equities should outperform convertibles, and the opposite is expected in bear cycles. Thus, this style embodies what I call the “flexible and adaptive” mantra that RIAs should incorporate in their businesses.

5. High Yield bonds Today we call them high yield bonds, though in the late 1980s they were commonly referred to as junk bonds. Back then, Wall Street infamy accrued to Michael Milken and Drexel Burnham as the market they helped create, full of excessively leveraged deals and leveraged buyouts (LBOs), collapsed. Bonds defaulted in large numbers and the investment public swore off the sector until the mid-1990s. Coinciding with the dot-com bubble, tech and telecom companies issued medium and low-quality corporate bonds. The market was revived, but took another step back during the three-year stock market decline from 2000-2002.

Since 2003, the market for high-yield debt has reemerged as a viable investment market, at a more substantial size (about $800B) than in the past. High yield bonds are where investors go to participate in the growth process for small-to-mid-size companies, but through debt instead of equities. Many well known companies now also issue high yield bonds, and the default rates declined markedly as this investment segment matured. Today, we think it is fair to characterize high yield bonds as a way to invest for growth with lower expected volatility than the stock market, but with a much higher cash flow return than equities typically provide.

6. Short Equity Also called “bear funds,” these can be very useful as part of an overall portfolio. When markets are expected to be range-bound or rising as the primary trend, we prefer to do any hedging with either single-short ETFs or index-short mutual funds, as the short positions in those cases are tactical.

7. Short Fixed Income I am not talking about short-term bond funds. Here, I mean mutual funds that perform inversely to the bond market. These funds can potentially profit from rising interest rates on US Treasuries and even high yield bonds. If you are an inflation-hawk, that is a nice tool to add to your shed.

8. Global Macro Myopic approaches that focus only on U.S. stocks, or on stocks and high-quality U.S. bonds only, are unnecessarily restrictive. This inflexibility can leave traditional “balanced funds” powerless in some markets. I am a firm believer that ultimate investment flexibility, in the hands of the right manager(s) is the key to long-term investment success. Some global macro funds offer that capability, and unlike traditional “balanced” funds, they are not limited to global stocks and high-quality bonds. The most attractive funds of this type look more like flexible hedge funds in a mutual fund package.

9. Currency Currency investing was the domain of Wall Street trading desks and hedge funds for many years, but several mutual funds are now available to U.S.-based investors to pursue growth of capital and income by owning bonds denominated in non-U.S. Dollar currencies.

The bonds’ income is converted into U.S. dollars and if the currency appreciates against the U.S. dollar during the holding period, that income will convert into a higher return in U.S. currency than in the foreign currency, as the exchange rate to dollars favored the non-U.S. asset (the bond). The opposite is true when the U.S. Dollar appreciates against the currency in which the bond is denominated. The idea of currency funds is to correctly forecast the direction of exchange rates, and profit from those forecasts through the use of government and corporate short-term debt in countries outside the U.S.

10. REITs Real estate investing is not new to most RIAs and their clients. However, you have many avenues by which to pursue your real estate exposure. While both the public and private markets offer numerous and varied opportunities to participate, one look at the past couple of years in this sector, and you can understand why I believe that whatever the allure of the private markets, you can rest easier with daily liquidity. That applies to mutual funds that invest in U.S. REITs as well as those focused on International markets.

So, alternative investing does not always mean alternative investment vehicles. Do what you can to meet the objective for the client, while doing what is necessary to deliver on their expectations. In the new world we find ourselves in, I think you may find that alternative investing through mutual funds can carry a good portion of the load for your clients, while taking a huge load off of you.

That means more time serving clients, cultivating relationships, seeking referrals to grow your practice, managing staff and overseeing the other parts of your portfolio. Heck, you might even find more free time and less stress as a result. That’s a nice “alternative” to the work-life balance many RIAs currently struggle to find.

Robert Isbitts is a principal and CIO of an RIA that serves clients as a wealth manager, and services other RIAs via wrap accounts and a mutual fund, which he lead-manages.

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Stephen C Winks said:

November 12, 2009 — 6:48 PM UTC

Excellant article.

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