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How to Integrate Alternative Investments Into High-Net-Worth Portfolios

Follow this framework to identify low-volatility hedge funds that can protect clients’ capital during volatile markets.

June 19, 2008
Sponsored by Rochdale Investment Management

by Garrett R. D’Alessandro, CFA, AIF®, Chief Executive Officer & President, Rochdale Investment Management

Increasingly, high-net-worth investors (HNWI) are seeking out alternative investments. Determining an appropriate allocation and investment for a client can be challenging. While many CPAs and advisors rely on historical returns to select hedge funds, the true value for HNWI depends on the forecasted volatility of a fund and its correlation with other assets within an existing portfolio.

HNWI benefit from an integrated approach in determining whether a hedge fund has merit for their portfolio. The following framework can provide an objective process to demonstrate to a client how the inclusion of a hedge fund adds value to their portfolio:

  1. Categorize hedge funds into appropriate segments based on historical and forecasted volatility.
  2. Categorize hedge funds by their investment strategy.
  3. Develop a correlation matrix between each hedge fund segment or specific hedge funds and the existing asset classes in the client's portfolio.
  4. Select hedge funds that meet criteria such as: length of existence, Sharpe ratio, maximum draw-down and performance versus benchmark.
  5. Run portfolio simulations with the qualified and selected hedge funds, using the correlation to determine which asset class(es) a potential 10 percent investment in the hedge fund would replace.
  6. Select only those hedge funds that raise the entire portfolio's forecasted risk-adjusted returns.

As most HNWI value capital preservation, this process can be simplified. Because hedge funds come in all types and they have new asset characteristics, it may make sense for a client to begin with a low-volatility hedge fund, then after a year of experience the advisor and client can consider if they want to increase the hedge fund allocation from 10 percent to 20 percent, while expanding to other strategies.

The first step would be to screen the hedge fund universe to arrive at only those hedge funds with long-term established track records demonstrating low volatility. Eliminate from consideration all hedge funds with risk above a certain threshold and maximum draw-downs during bear markets over the same threshold. What remains is a set of high-quality lower-volatility hedge funds.

Then consider whether the client is more conservative or growth oriented. For a conservative client seeking to integrate hedge funds, allocate 10 percent from their current equity asset allocation into a lower volatility hedge fund, while maintaining their fixed income exposure. This would in all likelihood reduce the overall portfolio risk level, while lowering the returns somewhat. However, the risk-adjusted returns would likely rise. For a growth investor, allocate 10 percent from their fixed income allocation into the lower volatility hedge fund, while maintaining their equity exposure. Again, the effect will likely be to reduce overall portfolio risk while raising risk-adjusted returns.

The potential contributions from hedge funds can be quite beneficial; however, there is a lot of misunderstanding of the risks associated with hedge funds. Not all hedge funds are created equal and not all hedge funds are risky. Just as there are riskier stocks and riskier mutual funds, hedge funds comprise a spectrum of risk and return opportunities. A hedge fund-of-funds that invests across a diversified set of multiple strategies and multiple managers is likely to be lower risk than a single-strategy or single-manager fund. While many hedge funds do use leverage to amplify returns, advisors can seek out lower-leveraged hedge funds for clients seeking lower risk. Hedge funds that have taken the extra step to register with the U.S. Securities and Exchange Commission (SEC) are usually more appropriate for clients new to the alternative investment asset class because the level of oversight and transparency can provide more information concerning the underlying investment strategies.

The recent financial system liquidity crisis could not have better demonstrated the ability of lower-volatility hedge fund-of-funds to achieve significantly less downside risk than the equity markets. Several hedge fund-of-funds showed superior risk management as these funds declined only 25 percent of the declines of the S&P 500, thus insulating clients from 75 percent of the market risk. When a bear market comes as quickly as this one did, only well-diversified multi-strategy funds with superior risk management techniques were able to avoid the significant declines of the more volatile single-strategy funds.

A lower-volatility multi-strategy, multi-manager fund of funds seeks to protect capital during down equity markets and capture some of the upside when markets are rising. While the goal should ideally be to provide positive returns on a yearly basis, during extreme market environments a small negative outcome may be acceptable.

In selecting a hedge fund-of-funds for clients, advisors would do well to seek a fund with:

  • The ability to be invested in some of the best hedge fund managers worldwide.
  • A comprehensive risk management approach to protect capital.
  • Broad hedge-fund manager diversification across multiple types of strategies.
  • Extensive due diligence performed on all managers.
  • Strategic allocation of capital to the more attractive strategies.

There are three aspects that really matter when evaluating a multi-manager, multi-strategy fund that delivers the benefit of downside protection during equity declines. First, by allocating capital across several types of alternative strategies, you eliminate the risks associated with single strategy funds. Second, a manager's investment process, key decision-making personnel, alpha generation and risk management are more indicative of future results than are historical track records. Third, finding managers able to successfully create alpha and outperform their respective benchmarks is paramount.

While the appropriateness of fund depends on many factors including the client's individual risk tolerance, for most clients seeking to enter the alternative investment space, a low-volatility multi-strategy hedge fund-of-funds employing low levels of leverage can be a solid first step.

Garrett R. D’Alessandro, CFA, AIF®, is Chief Executive Officer & President of Rochdale Investment Management, a private client money manager specializing in personalized portfolio management for high-net-worth individuals and families. For more information or for a confidential risk analysis of a client’s portfolio, please call Patrick J. Vignone, CPA, at 800-245-9888 or e-mail info@rochdale.com.

This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation by Rochdale or its affiliates of any product, transaction or service, including securities transactions and investment management or advisory services. The opinions expressed in this publication should not be considered investment, tax, legal or other advice and should not be relied on in making any investment or other decision.

Text and images in this article are Copyright © 2008 Rochdale Investment Management and may not be reproduced without the express permission of Rochdale Investment Management.