ARLINGTON, Va. — In their search to reduce portfolio risk, advisers are on the hunt for alternatives to their costly hedge funds and managed futures.

The low costs, convenience and liquidity of the mutual fund structure may be attractive to advisers, said John Dolfin, the chief investment officer at asset management firm Steben & Co. However, the low beta and positive alpha of equity long/short hedge funds, for example, may be a better alternative.

“Mutual funds that trade equity long/short have been generating all of their returns from beta, and that’s not the return source that we want." — Steben & Co. CIO John Dolfin.

“The problem with getting your returns from beta is it requires no skill, and you shouldn’t have to pay hedge fund-like fees for something that requires no skill,” Dolfin said at NAPFA’s Fall Conference. “You can do that yourself with ETFs. It’s very cheap and easy.”

Fees associated with most equity long/short hedge funds, for example, are significantly higher than those of similarly structured mutual funds for the low returns they provide. However the high-touch management may ultimately prove to be more beneficial, he argued.

Source: BarclayHedge – All Equity long/short hedge funds, Morningstar – All equity long/short mutual funds.
Source: BarclayHedge – All Equity long/short hedge funds, Morningstar – All equity long/short mutual funds.

Advisers contemplating a change should seek strategies and managers with low correlations to traditional assets, consider managers with high alpha and lower beta compared to peers and check that managers have unique trading ideas that differ from the rest of the pack, he said.

Although the hedge fund industry has become ever more correlated to equities, requiring extra care in selecting strategies and managers with low correlation, data published by Steben & Co. in May shows mutual funds providing significantly higher beta and lower alpha than similar hedge funds.

Source: BarclayHedge – All Equity long/short hedge funds, Morningstar – All equity long/short mutual funds.
Source: BarclayHedge – All Equity long/short hedge funds, Morningstar – All equity long/short mutual funds.

“This to us was quite damning of the current level of quality of mutual fund equity long/short funds. That says you can still find good managers in the space — you just have to look and do the analysis,” he said. “Mutual funds that trade equity long/short have been generating all of their returns from beta, and that’s not the return source that we want.”

In contrast, Kris Johnson, an adviser with Timothy Financial Counsel in Wheaton, Illinois, said his firm’s core structure accepts the beta in the market, leading them to focus on ETFs and mutual funds as an alternative.

“That’s the risk we’re taking with the core of the portfolio, and I think some of the strategies out there are other things to potentially diversify away from,” Johnson said. “The focus of what we do is ETF and mutual fund structures that are mostly traditional.”

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Prior to the last three years, there were fewer mutual funds that provided the cost and liquidity benefits advisers need, Dolfin said. Nearly every equity long/short mutual fund currently available has negative alpha, “which means you have lower fees, but you are also getting lower skill,” he said.

Private hedge funds, meanwhile, have higher alpha and lower beta than mutual funds trading in the same strategy, Dolfin explained.

Dolfin said advisers are going to have more luck improving their portfolio than in going the mutual fund route, at least at the moment.

Brian Nikulski, president and chief compliance officer at Nikulski Financial, said his fee-only RIA is staying away from mutual fund replacements for hedge fund allocations because of the risk. The alternative for their firm are ETFs, yet there are still problems using those, he said.

“We use ETF individual stocks and bonds, so finding a structure that’s non-mutual fund is what we’re looking for,” Nikulski said. “Once the strategy becomes more mainstream on the ETF structure side, I think that becomes more valuable for us to use.”

Nikulski said one issue his firm has is finding sufficient data to examine any risk associated with including hedge fund allocations in their clients’ portfolios.

“What I have noticed is finding accurate correlation data can be a challenge at times to analyze the risk and the benefit of these types of investments,” he said. “We use a core satellite strategy where some accept beta and some hedge for alpha.

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Andrew Shilling

Andrew Shilling

Andrew Shilling is an associate editor for Financial Planning, Bank Investment Consultant, On Wall Street and Money Management Executive. Follow him on Twitter at @AndrewWShilling.