RIA’s Turning to Alternatives

After the financial meltdown of 2008, a “flight to safety” defined the investment landscape in 2009.   But if media headlines are any indication, 2010 may be defined by a boomerang effect, caused by advisors shifting client portfolios away from ultra-conservative holdings into more alternative investments such as hedge funds, currencies, limited partnerships, structured notes, private equity, etc.  The recent period of market calm may also prompt some clients to consider switching advisors, which could put pressure on advisors to increase short-term performance.

Betting on Currency

According to a study from Rider University, which I found in “Betting on Currency” from Financial Advisor Magazine, advisors are adding currencies to their client portfolios to simultaneously reduce risk and improve returns.
The report suggests that financial advisors shouldn’t depend just on foreign stocks or bond funds for currency diversification.  The reason being that foreign stock markets have higher correlations with U.S stocks, while foreign currencies have a lower correlation.
Advisors may also be attracted to foreign currencies due to the looming threat of inflation.  “The U.S. is printing more money than other countries,” states Axel Merk, manager of the Merk Hard Currency and Absolute Return Fund. “The dollar is weak and deteriorating.  A flight to safety will benefit the U.S. dollar less than in the past.  The U.S. dollar will be a loser for the very long term.”

A Hedge Fund Resurgence

After four quarters of net withdrawals, hedge funds recorded net asset inflows in the third quarter of 2009 — adding $1.1 billion in new capital, according to a recent recent survey by Financial Research Corporation.  RIA firms were responsible for some of these asset flows and some have plans to invest more.  In fact, advisors in the RIA channel are more comfortable with alternative investments including hedge funds than their wirehouse counterparts.

According to Ron Fiske, Executive VP at Fidelity Institutional Wealth Services, assets on their alternative products platform grew 50% in 2009. In a study of 200 RIAs, more than half plan to increase their allocation to alternatives, including hedge funds, in 2010.

Advisors Face Knowledge Gap

An article in Financial Advisor Magazine, quotes a report from Cerulli, saying that while many alternative investments did poorly themselves, most still outperformed market benchmarks.
The Cerulli report shows that there is a lot of room to grow since most advisors haven’t used alternatives in clients’ portfolios: Fewer than 10% of advisors surveyed by Cerulli have put client money into hedge funds, limited partnerships, structured notes or private equity.  Slightly more advisors use commodities (15%) and managed futures funds (13%).
Some advisors are increasingly turning to their broker-dealer’s internal research teams through managed account programs that can offer client risk-profiling and incorporate a variety of strategies in one account, Cerulli found.

The Pros & Cons of Overlay Portfolio Management Outsourcing

Excerpts from the 2009 MMI Technology & Operations Conference.

The speaker for this session was Randy Bullard, Executive VP, Institutional Business Development, Placemark Investments.

What is Overlay Management?

Randy began by breaking down Overlay Portfolio Management (OPM) into two main components:

  • Administrative/Operational Functions – Mostly accounting tasks such as simple asset class rebalancing, managing cash flows, wash sale prevention, and tax management.
  • Investment Management Functions – Involves more human and quantitative portfolio management judgment, such as making balanced decisions, risk vs tax value for a client.

Variables to Consider

OPM is a classic insource/outsource decision. Randy provided a few variables to think about:

  • Scalability – At what point do you get to scale? When does it make sense to insource it? It’s usually around $2 bil in AUM for most firms to go economically right-side up, Randy asserted. Assuming they have appropriate staffing levels and delivering fairly robust functionality. Up until the $2 bil threshold, you tend to be upside down.
  • Capability – The more investment management-oriented functions within OPM are very much a quantitative investment management discipline. If your firm doesn’t have that in-house or isn’t prepared to staff it, then you should consider outsourcing.
  • Firms should be honest when estimating startup costs.
  • Firms should understand the costs of compromise. A number of those programs launched with 5 models and very little or no customization capability, no tax management, flexibility or other advanced feature sets. These are all now initial costs of entry in order to grow assets.

Technology Impact of Models-Only UMA and UMH Programs

Excerpts from the 2009 MMI Technology & Operations Conference.

The speaker for this session was Jean Sullivan, Managing Director at Dover Financial Research.

What is the Technology and operational impact of the increasing growth of model only programs, UMA and UMH? How are firms on all sides of this process managing the challenges these programs present?

The rate of growth of SMA’s asset levels have declined consistently since 2007, Jean reported. Some people think that the SMA industry is a dinosaur and the SMA investment product is obsolete. Dover doesn’t buy into that theory. They believe the SMA marketplace is in transition. Given the down market, the SMA investment product isn’t a good product and doesn’t meet investor or FA needs, Jean asserted. Once the market picks up again, she advised, SMA asset levels will rebound.

What’s the future of model portfolio programs?

“Our research shows that these programs just make sense and have a lot of advantages,” Jean reported. They offer efficient ways to deliver investment management, they allow investment managers to focus on their core capability of portfolio management, eliminate some unnecessary infrastructure, they enable functionality such as tax management customization which enable UMA’s to deliver on their value proposition, which is making sophisticated PM techniques more simple and available for FA’s. Within the UMA sector, model portfolio programs will continue to dominate.

What’s the future of UMA/UMH Platforms?

”We believe that the future of the industry lies in the UMA/UMH platform,” Jean stated. “In all of our interviews, every single sponsor said that fully-integrated, UMA/UMH platforms were a core initiative. The market crisis exposed vulnerabilities in UMA/UMH programs: they lack flexibility, they lack simplicity. Make life easier for the FA, make processes and portfolio construction simpler. UMA’s have been positioned as another platform, but what investors need are total solutions. Instead of an FA just selecting another platform they want to know ‘How can I facilitate retirement for my client?’ ‘How does wholesaling take place?’ ‘What’s the service model around UMAs?’ We clearly need to build more infrastructure and more functionality,” Jean argued.

This is an opportune time for the industry to retrench and digest current trends, Jean emphasized. It’s a great time to begin to identify inefficiencies in the existing infrastructure. There’s a huge opportunity for the industry to create communication standards to help firms become more efficient and mitigate risk.

Click here to download the powerpoint slides for this session.