Alternative investments have been a hot topic among investment company executives. But so far, investors have yet to give them a warm reception.
Mutual fund industry data show that asset flows into most alternative investments, while positive, have been slow and downright disappointing, causing sponsors to trudge back to the drawing board and rethink how to best teach brokers and reach investors.
In stark contrast, traditional hedge funds have been soaking up assets. Estimates show that assets in traditional U.S.-based, offshore and global hedge funds have increased 35% over the life of this bear market, from $480 billion at the end of 1999 to a collective $650 billion at the end of last year, according to Van Hedge Fund Advisors International of Nashville, Tenn. That figure is expected to soar to $900 billion next year, while the sheer number of hedge funds is expected to top 8,500 by year-end 2004, up from 6,200 that were available in 1999.
Meanwhile, in the highly regulated mutual fund arena, hedge fund-like products based on a variety of sophisticated investment techniques haven't entirely impressed investors. Nor have these products caused investors to eagerly open their wallets, despite promises that these new products can weather any storm, provide absolute returns and reduce volatility.
Two separate categories of alternative investments have emerged over the past few years. On the open-end mutual fund frontier, so-called market-neutral funds as well as long-short funds have trickled out to investors since 1997's repeal of the Short-Short Rule, which prevented funds from vigorously trading portfolio securities.
Market-neutral funds take no bet on the direction of the markets, investing 50% of assets in long positions, and 50% in short positions in an effort to "neutralize" overall positions and profit no matter which way market sentiment shifts.
In contrast, long-short funds aren't afraid to bet whether markets will turn bullish or bearish, and will load up on either long securities' positions or short positions to take advantage of any market condition. Fund managers typically hold long positions in undervalued stocks with good prospects, and short stocks judged to be overvalued or just plain stinkers.
Although these investment techniques have slowly infiltrated the mutual fund universe, investors haven't flocked to their doors. According to Lipper, Inc., total assets across all market neutral and long-short funds stood at $2.2 billion at year-end 2002, less than a 3% increase from $1.7 billion at year-end 2000, and only 14 investment firms had thrown their hat into the ring, including two that feast on a steady diet of merger arbitrage.
A few category winners have attracted the lion's share of assets in the midst of this bear market. The Consulting Group Capital Markets' Multi-Strategy Market Neutral Fund, which is offered exclusively within Smith Barney's TRAK program, ended 2002 with $212 million in assets, according to Lipper. The Calamos Market Neutral Fund, managed by Calamos Investments of Naperville, Ill., has seen assets increase 12-fold over the past two years, soaring to $663 million at year-end 2002. Assets in the Axa Rosenberg Long Short Fund have more than doubled to 135 million in the past two years. The Boston Partners Long-Short Equity Fund has seen its asset balloon 600% to $110 million from under $2 million in 2000.
Hoping to further entice downtrodden investors with positive returns that don't correlate to either the equity or bond markets, companies are also trying their hand at a new breed of SEC-registered 40 Act hedge fund of funds. These funds are structured like closed-end interval funds and typically invest in one or more outside traditional hedge funds.
An amazing 46 different SEC-registered hedge funds have been registered between January of 2002 and March 31 by both traditional hedge fund firms and mutual fund companies, although many have not yet officially launched. Newcomers to this arena include American Express Financial Corp., Columbia Management Company, Nuveen Investments, J.&W. Seligman and Co. and even General Motors Investment Management Corp., which last November registered its GMAM Absolute Return Strategy Fund I.
And more are on the way. Pioneer Investment Management of Boston has confirmed that plans to launch the open-end, Pioneer Market Neutral Fund, which was registered last year, have been tabled in favor of debuting an SEC-registered hedge fund of funds later this year.
Avi Nachmany, EVP and director of research at Strategic Insight of New York estimates that these hedge fund of funds have collectively pulled in only $500 million. "The process of introducing down market registered hedge funds is very lengthy and slow," Nachmany said. Changing the mindset of investors so that they understand how these products manage risk as opposed to viewing them as speculative investments is key, he added.
According to research from Parker Global Strategies, a hedge fund manager of managers in Stamford, Conn., while some early market entrants such as UBS Paine Webber, Goldman Sachs, Global Asset Management and OppenheimerFunds have had success in garnering assets, myriad challenges exist. Sponsors face significant organizational and operational expenses as well as having to shift substantial resources to train wholesalers and educate both distributors and investors.
"There's a disconnect between product manufacturers and consumers," said Ken Phillips, managing principal of RCG Capital Partners in New York. "There's a desire to get these products in front of advisers and have the client just understand these. Customers are not as much demanding these products as product manufacturers are seeing what they can put in front of advisers."
It takes a tremendous amount of work and education for clients and advisers to open up to different strategies that can produce favorable results no matter what the market does, said Craig Russell, global head of marketing and sales at DB Absolute Return Strategies, the alternative investments unit of Deutsche Bank which debuted its first registered hedge fund, the DB Hedge Strategies Fund, this past September. To broaden distribution, three weeks ago the unit partnered with Raymond James. The fund has amassed almost $28 million.
"There is a steep learning curve that everyone underestimated," said David Anderson, managing director of Global Asset Management in New York. Not only must brokers understand what these products are, how their strategies work, how they correlate, etc. but the investment process is tedious. Investors must complete and return pre-qualification forms attesting to their status as accredited investors, branch managers must review and approve documents, and so on, he added.
Despite the apparent uphill battle, investors will eventually come to embrace alternative investments as a necessary component of a well-balanced portfolio, many predict.
Allocating a small portion of a portfolio to alternative investments can make sense, especially for investors who have overreacted to the equity market meltdown and over allocated assets into the fixed-income market, especially in anticipation of interest rates eventually rising, said Tim Williams, director of product management at Smith Barney's The Consulting Group.
Alternative investments are not a fad, said Rick Lake, of Lake Partners, an alternative investments portfolio manager. "In a world where uncertainty and chaos reign, investors need as many tools as possible."
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