Bank Investment Consultant
Alternative investments — hedge funds, commodities, real estate, and private equity — are risky business.
They tie up an investor's money, sometimes for years; can collapse in a heap of red ink overnight; require huge investments just to play and considerable due diligence, often for no extra fee.
So why would bank-based financial advisers care about them?
The answer, says Tom Melcher, a managing director at Hawthorn, PNC Financial Services Group Inc.'s ultra-high-net-worth group, is to help reduce a portfolio's volatility without cutting into its return.
"Take a typical client," he said. "He might have a $3 million portfolio invested 60% in equities and 40% in bonds. The equities historically show an 11% return over time with volatility in the low double digits, and the bonds, a 6% to 7% return with a very low standard deviation. What we might do is suggest a hedge fund that has had a historic return of about 11% with a 5% standard deviation. Then we'd move 5% of the portfolio from stocks and 5% from bonds into the hedge fund, so that the portfolio would be 55% equities, 35% bonds, and 10% alternative investment."
The client, he said, would enjoy a slightly higher overall return, given the 5% shift out of bonds, and the volatility would be lower, since the hedge fund would not correlate with the volatility of the equities market.
"The returns over time can be better than bonds," Mr. Melcher said. "Some alternative investments can even outperform stocks, and there will generally be a low correlation to other assets."
The ideal, he said, is to invest in products so that, "if stocks rise, your alternative investments are flat, and if stocks go down, your alternative investments rise."
Darryl Presley, a financial adviser for Invest at First Bank in Lexington, Tenn., offered the example of a 65-year-old lawyer with a nest egg of $250,000 in a 401(k) plan who wants to retire soon, or at least to cut back on his legal work.
He said it would be important, in this example, to start drawing income from that asset pool without eating into the principal, but investors are worried about the market and want CD-like return.
Mr. Presley suggested investing in nontraded real estate investment trusts.
"Putting your money into a REIT can give you a better return than a CD without having to worry much about volatility," he said. "As long as you can handle that that $50,000 of your portfolio will be illiquid for a few years, this can be a good investment."
With steadily lowering minimum investment requirements, clients are increasingly asking broker-dealers about how they can invest in alternatives. But despite their advantages, alternative investments can tie up assets, said Eileen Alden, a product manager at Wells Fargo Bank in San Francisco.
"As a financial adviser, you need to clarify with the client that, with alternative investment products, there can be liquidity issues," she said. Some products may offer monthly opportunities to cash out and good transparency, while others can lock up assets for 10 years.
This is why most firms set guidelines about who can invest in alternative strategies. Rules can vary widely among institutions.
Mr. Presley, who deals with fairly small investors and whose bank requires a minimum liquid asset of $250,000 or an income of at least $60,000, said: "You need to really explain to the client that these investments can be pretty illiquid for some time. You need to check out their assets before they invest in something like a REIT."
Alternative investments carry risks for advisers, too. To mitigate the risk, Fred Whaley, a managing director of wealth solutions at Raymond James in St. Petersburg, Fla., said his firm requires clients who want invest in alternative products to complete an investor qualification affidavit.
It's a good idea, because with hedge funds or private-equity funds, investors can lose principal if things go sour, and they need to understand these risks.
Also, Raymond James clients, working with the bank rep, must draw up a current balance sheet. "If there's ever a time to re-check your knowledge of a client's financial situation, it's before making an alternative investment," Mr. Whaley said. "You need to be very certain that you know what your client's portfolio looks like."
Mr. Melcher said alternative investments also carry higher costs, tax consequences, and risk.
"It may be sexy to say you're in alternative investments, but it may not be good for your portfolio." PNC's Hawthorn group deals only with clients who have a net worth of $20 million or more. Even then, Mr. Melcher said, it is critical to determine who really needs alternative investments.
Wachovia doesn't take any chances, either. "We limit these investments to people who have at least $1 million in liquid assets to invest," said Tim Froelich, the director of alternative investments at Wachovia Securities in Richmond, Va. "But even then, there can be higher restrictions. For example, if it's a registered hedge fund, they have to have a net worth of $1.5 million. For some hedge funds, the SEC can require a minimum of $5 million to qualify."
It's important to focus on the basics, Mr. Melcher said: "What do they have to invest, what time period are they thinking about for reaching their goal, and what is the goal? Is it income? A nest egg for the family? Philanthropy?"
Advisers also have to figure out whether the client is interested in reducing volatility, increasing return, or both. Certain hedge funds, for example, are conservative by design, and are excellent for reducing volatility. Others are aggressive, and can substantially increase a portfolio's return, but at a substantially greater risk.
Despite the risk to both client and adviser, many banks don't charge clients extra for investing in alternatives, but for advisers managing fee-based accounts for wealthy clients, a win for the portfolio is a boost to that adviser's revenue stream. And above all else, with the publicity that alternative investments are getting, wealthy clients are clamoring for them.
