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An Alternative Approach

Last year changed the landscape for hedge funds and other alternatives.

What happened to hedge funds in 2008? Like so many other strategies, they had, on average, a horrendous year, posting their worst performance on record, a decline of 19 percent; dozens of high-profile funds blew up and nearly one-third of the hedge funds tracked by Morningstar closed shop. The thing is, your stereotypical hedge fund (if there is such a beast) was supposed to be different: An alpha generator with the mandate to go anywhere, to claw out gains regardless of the direction of the capital markets.

The alternatives landscape has fundamentally changed, even if last year represented a black-swan event, says a reccent white paper, called “Alternatives 2.0: What is the Prudent Investor To Do,” and sponsored by Rydex and SGI Security Global Investors. Stronger performance may have returned this year — most indices that track hedge funds showed gains of around 9 percent, on average, through May, and redemptions have slowed significantly. But that doesn't change the fact that for some, last year's losses will likely never be recovered.

In the new environment, alternatives have become an even more crucial part of wealth management, the paper suggests. This may be especially true as more hedge fund products become available to retail investors in a variety of wrappers — 1940 Act mutual funds, managed accounts and, for the first time this year, ETFs. But advisors will have to be much more disciplined about selecting non-correlated alternative strategies and making them fit together into client portfolios, the paper says.

The Upset In '08

Hedge funds are generally expected to perform well regardless of the direction of equity markets because correlations between hedge funds and equities are typically low. But last year, correlations proved to be relative, says Maarten Nederlof, co-author of the white paper and principal of consulting group Safari Advisors. For one thing, there was more exposure to equities in many hedge funds than people thought.

The other problems were less of a surprise: leverage and liquidity. Because the hedge fund space has gotten more crowded over the years, competition increased, managers began mimicking each other, and returns shrank. In order to continue to get equity-like returns, many hedge funds piled on the leverage. When managers began to get margin calls, they couldn't sell their illiquid assets and so they sold what equities they had instead, putting further pressure on the equity market and reducing their liquidity. The result was a major liquidity crunch.

Even if last year was a black swan — an event so rare that it is highly unlikely to occur again in decades — the kind of shock that losses on the order of 20 to 40 percent deliver to portfolios is too great to ignore, the paper says. It can be difficult to make up for those kinds of losses even over time because of the effects of compounding. The lesson of last year's upset, then, is that financial advisors need to begin to focus more on downside risk.

Alternatives can help with this. They still offer better risk/reward efficiency, when used properly, than equities and bonds do over time — and this was the case even during the last market decline. Between January 2007 and December 2008, a standard portfolio of 60 percent equities and 40 percent bonds would have posted an average annualized return of negative 8.8 percent, where as a portfolio with 50 percent equities, 30 percent bonds and 20 percent alternatives would have returned negative 8.4 percent, says the paper (okay, it was slim).

But the process of due diligence that financial advisors need to conduct before selecting altenatives has become much more complex. “Selection, modeling and allocation techniques must be much more robust in their treatment of alternatives,” the paper's authors write. For example, the mix of alternative strategies that is right for a particular portfolio needs to be determined not just based on traditional risk/return measures, but after an examination of the leverage, liquidity and transparency characteristics of each strategy, their exposures to key market risks, the way they respond to volatility, and how they stack up against other portfolio holdings by these measures.

Some advisors may also want to consider newer more transparent vehicles, such as ETFs and mutual funds that use hedge fund-like strategies, or even hedge funds wrapped in managed accounts, a structure to which many hedge funds have moved since the beginning of 2008. A couple of hedge fund ETFs have been launched in recent months, and many more have been filed with the SEC. In late March, IndexIQ rolled out the first, called IQ Hedge Multi-Strat ETF (QAI), which has exposure to all of the major hedge fund strategies. More are in the works from IndexIQ and WisdomTree Investments.

“The benefit is that you can buy it and sell it within a minute, the transparency, the tax benefits, the convenience and, of course, the fees,” says Rob Ivanoff, research analyst with Financial Research Corp. of Boston. On the other hand, the ETFs are, obviously, new and untested as of yet.

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