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The Wealth Advisor: The Affluent Are Searching for Relief in Alternatives

If you want to attract high-net-worth clients, our survey shows you'll need to offer high-net-worth sophistication.

Theoretically at least, the rich shouldn't care if it's a bull or bear market. That's because the rich have so many investment options — they can go completely short, or pick a cocktail of alternative investments, that, theoretically, could hedge away risk. The less rich, on the other hand, have fewer non-equity correlating vehicles to choose from. According to data compiled from three separate surveys we conducted from 2000 to 2002, the affluent have taken full advantage of those options and put progressively more money into investments other than stocks, bonds and traditional mutual funds in each year of the current downturn.

Each year, we asked three different affluent groups where they were investing. Not surprisingly, the affluent have steadily redeployed their investable assets toward alternative and “other investments.” (See table.) In our three-year survey, we asked the same set of questions to three different groups of affluent investors; a total of 754 participated. All of them had at least $1 million in investable assets and about one quarter, 213, had more than $3 million. In our surveys, “alternative investments” are hedge funds, private equity funds and funds of funds; “other investments” includes real estate, collectibles and direct business investments.

We also found that the wealthier the investor, the more likely he was to participate in these risk-reducing investments. In fact, by 2002, alternative investments were number one with this segment; mutual funds, by comparison, had slipped all the way to single digits. (See second table.) Obviously, average investors weren't included in the surveys, because they are non-accredited (meaning they have annual income below $200,000) and cannot legally invest in the high-end vehicles.

One reason for the growth in popularity of non-correlating alternative investments is availability. More and more hedge funds are registering with the SEC, allowing them to lower minimum antes (to say, $25,000, versus the hundreds of thousands or millions needed to gain access to the best funds in prior years). By registering, the hedge funds can increase the number of investors they can appeal to (see related story on page 42). In addition, registered funds tend to have less complex offering processes, rendering them nearly as familiar as mutual funds. One reason for the rise in these new products — particularly of funds of funds, which spread out investment among a handful or more managers and styles — is risk-reducing diversification. Another motivating force: Advisors with affluent clients are sophisticated enough to put the higher-end products to best use.

Of course, the lengthy downturn in equities has inspired many investors to get reacquainted with diversification — the idea being that going along with the S&P 500 is not prudent financial planning. During the last years of the bull market, as investors threw money at tech stocks and funds, diversification and asset allocation alike were skewed — and portfolios suffered accordingly. Alternative investments — including real estate and art — offer diversification and can lessen the pain of capital market losses.

Not that they've all been winners, mind you. A recent study found that through the 12 months ending September 2002, private equity funds had lost an average of 22.3 percent. But such investments nonetheless offer an option that's not correlated to the stock market. No investment is a sure thing, of course, but as an advisor targeting high-net-worth clients, you're going to have to learn what your firm or b/d offers in the alternative category.

Investments made in the previous year, 2000-2002
2000 2001 2002
Stocks and bonds 83.3% 64.4% 53.3
Mutual funds 52.0 35.3 29.7
Alternative investments 17.1 24.5 33.0
Other investments 11.9 21.6 23.6
(N= 294 in 2000, 278 in 2001, and 182 in 2002. Source = Merrill Lynch Investment Managers and Prince & Associates.)
Investments made in the previous 12 months (2002)
$1m-3m More than $3m
Stocks and bonds 53.4% 53.1%
Mutual funds 38.3 6.1
Alternative investments 21.1 65.3
Other 16.5 42.9
(N= 182 investors. Source = Merrill Lynch Investment Managers and Prince & Associates, 2002.)

It's easier than ever to become an expert. Over the last few years, there's been far more media coverage of and investor education about alternative investments, and this has helped demystify them for advisors and retail investors alike. This has been particularly true among financial services firms that have ratcheted up their pursuit of the wealthier clients. Indeed, most firms have been heavily promoting the products to better appeal to this coveted class of investor.

Then there are the emotional reasons for being enamored of alternative investments. The last three years have damaged the portfolios of American investors, but they also have battered their psyches. Even the most affluent investors — those with access to the all best investment options and advisors — have not emerged unscathed. But our survey shows that they continue to follow the best path available to them: spreading risk by moving away from traditional investments, such as stocks and bonds, to seek refuge elsewhere and embracing alternative investments.

Writers' BIOS:
Russ Alan Prince
is president of Prince & Associates.

Hannah Shaw Grove is managing director at Merrill Lynch Investment Managers.

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