Hedge funds and other forms of alternative investing have never been for the faint of heart. John Paulson led his investors to fantastic gains by betting on the collapse of the housing market, but as of a month ago his largest funds were experiencing double-digit losses.

Nevertheless, the same or worse could be said about the broad equity markets, which have been on a crazy ride since September 2008. That's why wealth management firms have started adding alternative investments to their menu of choices to meet the desire of clients to reduce volatility in their portfolios.

"There has been more demand over the last year," says Richard Gill, vice president of business development and acquisitions at Focus Financial. "I think people are interested for a number of reasons. Although some alternatives have performed badly and others well, there is an interest in capital preservation above all else."

Focus Financial signed on to a partnership in November with alternative investment platform provider CAIS. Alternative investments offer exposure to assets that are less correlated to the equity market, such as commodities, emerging market debt and high-yield bonds. An alternative investment strategy might also involve derivatives to hedge downside risk - a main objective of including alternative investments in portfolios, after all, is to reduce volatility.

Frank McCarthy, vice president and general manager of Ameriprise Financial Services' external products group, agrees that alternative investments can smooth the volatility in a client's portfolio, reducing risk and increasing overall return. "A lot of advisors and their clients saw that in 2008. One of the only asset classes that was positive was managed futures," he says.



There is evidence suggesting alternatives do reduce volatility and downside risk while maintaining similar if not better returns to equities. The data is somewhat limited, however, because the products are either new or have been unlisted and have offered little transparency.

An Ibbotson study updated in the Financial Analysts Journal last year shows that hedge funds achieved value-weighted annual returns of 11.8% between January 1995 and December 2009, virtually the same as stocks after fee adjustments. Hedge funds, however, had a standard deviation, which measures volatility, of 5.7%, compared with equity's 15.8%.

A similar argument can be made for certain exchange-traded derivatives strategies. An Options Industry Council study published last year showed that a buy-write strategy on the Russell 2000 index in the 15 years prior to 2011 generated annual returns that were nearly 10% higher than a buy-and-hold strategy on the index, with a standard deviation that was 20% lower. Investment managers such as Bridgeway Capital Management and Rampart Investment Management offer funds using strategies such as the buy-write, in which the investor sells calls on a security he or she owns and uses the premium to offset stock-price drops.



Prior to the agreement with CAIS, Focus Financial had not done a lot of work with alternative investment providers, according to Gill. The firm was especially attracted to CAIS' selection of single-strategy hedge funds in which clients can invest small portions of their portfolios, say between 5% and 10%. In fact, CAIS is providing independent advisors' customers with access to some of the biggest names in the hedge fund business, including Paulson & Co., Millennium Management and D.E. Shaw.

The CAIS platform allows for much lower minimum investments than what those hedge funds would normally require, and lower fees. And from a wealth manager's perspective, researching, performing due diligence and monitoring individual hedge funds can take up an inordinate amount of time and resources. Those functions are performed by CAIS, which provides the information in a fully transparent way to its customers.

"It allows our firms to open up their universe [of investments] a bit. Now they can access single-strategy hedge funds if they so choose," Gill says.

When discussing the investments with customers, he adds, advisors at those firms can note that essential operational and investment due diligence on those funds is performed by well-respected Mercer Investment Consulting. Meanwhile, fund administration, custody and reporting services are done by State Street and provided in a standard format, enabling advisors to explain precisely how an investment fits into a customer's portfolio, and its potential risks and rewards.

Sam Holloway of Holloway Wealth Management of Gainesville, Fla., says financial advisors are increasingly expected to play a more direct role in the asset management process rather than outsourcing that responsibility to a third party. That makes transparency essential.

"Clients want you to look them in the eye and make the call on their money," Holloway says, adding, "Advisors need to be able to defend their positions and how they manage risk. The mind-set of Americans now is risk management first and returns second."



The skittishness among investors is understandable. Although the stock market had been on a bull run for years, by 2009 it sure didn't feel that way, says Kevin Malone, president and founder of Chicago-based Greenrock Research. Greenrock provides registered investment advisors with research services and consulting services concerning managed accounts.

Malone notes that equity returns were essentially flat from 2000 to 2010 and in fact would have been negative were dividend income not included. Investors have endured sizzle-and-fizzle cycles with very few gains to show for their trouble. That's likely to continue, says Malone, since "you do not get appreciation of common stock unless you have periods of economic expansion."

The last decade, instead, was fueled by low interest rates that resulted in debt-fueled bubbles. For true economic expansion, in which genuine wealth is created and returns are predictable, Malone says the U.S. has to turn the pages back to the post-World War II era and the rebuilding of America from 1946 to 1968. The next and last expansion period occurred between 1982 and 1999, when technology reshaped business and production.

The next expansion will likely come from building the middle class in the developing world, Malone says. He isn't completely pessimistic about the developed world's prospects - it survived the skyrocketing inflation of the late 1970s, after all, despite the gloom and doom of skeptics.

However, until it unwinds the enormous public and private debt it has accrued - and that won't be for a long while, he says - it will be difficult to predict a total rate of return on investments. Without that economic expansion, Malone says, volatility will continue - boosting interest in alternative investments that may bring a measure of stability to clients' portfolio.


Donna Mitchell is a senior editor of Financial Planning.