Alternative Mutual Funds Rise to the Challenge as Hedge Funds Slip in Status

The 2012 Morningstar Barron's Alternative Investment Survey, released on June 24, 2013, explored every facet of how advisors and institutions perceive the current landscape of alternative investments. This is the seventh annual survey, and it presented a tidal shift in some results. For the first time, for instance, it appears that institutions are starting to use alternative mutual funds to replace certain hedge fund investments. As another example, when presented with the all-important allocation question, the 2012 survey found that fewer advisor respondents (4% compared with 17% in 2008) chose not to allocate to alternatives, and most (63%) leaned toward a 6% to 20% middle-of-the-road allocation. Institutions were more polarized in their responses, with very small or very large allocations to alternatives. Additionally, while both advisors and institutions look to alternatives primarily for the diversification/low correlation benefits, advisors are also clamoring for new sources of yield. Finally, this year's hot-topic responses from both the advisor and institutional camps overwhelmingly favored lower fees and greater transparency, both attributes of mutual funds.

Paradigm Shift Into Mutual Funds
The 2012 survey shows that institutions are shifting their focus to mutual funds, shunning hedge funds in certain strategies such as long-short equity, to gain access to more-liquid instruments. Results showed that 45.3% of institutions primarily use mutual funds to gain access to long-short equity strategies, for example, compared with 26.0% that use hedge funds. In 2010 61% of institutions accessed long-short strategies through hedge funds, and only 38% used mutual funds. There are several reasons why an investor would prefer a mutual fund over a hedge fund: daily liquidity, increased transparency, and lower fees. It's more likely, though, that institutions are leaning toward mutual fund alternatives because there are an increasing number of higher-quality, seasoned managers in alternative mutual funds. There are currently 15 long-short equity mutual funds that have more than $100 million in assets with manager tenure of at least three years, for example. In Morningstar's hedge fund database, there are 67 U.S. long-short equity hedge funds with more than $100 million in assets, and only six with more than $1 billion in assets. Likewise, there are eight long-short mutual funds with more than $1 billion in assets.

Advisors Adopting Alternatives
It now appears that a much larger percentage of the advisor population allocates to alternatives from five years ago. In 2008 17% of advisors responded that they allocated nothing to alternatives; in 2012, that number fell to 4%. The drift into alternative investments since 2008 can be traced to the desire for better diversification and an extreme thirst for yield. Both groups (78% of institutions and 75% of advisors) cited diversification/low correlation as the primary reason they are allocating to alternatives. When asked to pick three top drivers to invest in alternatives, advisors cited the need to offer clients investments they wouldn't find on their own (29%). The search for better diversification is likely driven by the 2007-09 financial crisis, when investors who simply allocated to various long-only equity investments got burned. The S&P 500's largest drawdown during the crises was 55.0% while the MSCI EM Index lost 63.4%. It is not surprising, then, that long-short equity strategies, which only lost 24.8% during the crisis, rank as the top strategy for increased allocation among the survey's institutional respondents and third for advisors.

Since 2008, investors have flocked to bonds as a means to diversify stock market risk. But the 2012 survey pointed out a rising apprehension related to bonds. About 18% of advisors now cite a poor bond market outlook as a motivation to invest in alternatives, up from 9.7% in 2011. Even more advisors are looking to alternatives for enhanced yield (27.6% in 2012 compared with 14.7% in 2011), as bond yields hovered near historic lows. The non-traditional-bond category, for funds that can hedge credit or interest-rate risk, is the largest alternative category with an astounding $90.2 billion in assets as of May 2013.

In the search for yield, advisors are turning toward private real estate (such as nontraded REITs). Free-response answers from advisors highlight other investments with high-yield characteristics, such as master limited partnerships and business development companies. Interestingly, private real estate ranked sixth among institutions.

Institutions Bifurcated, Advisors Concentrated
When it comes to the question of "how much?" institutional investors appear to be split. More than 20% of institutions said that they expect to allocate more than 40% to alternatives in the next five years, compared with 17% last year, while about 28% invested between 0% and 10%. Advisors, when asked how much they currently allocate to alternatives, tended to be in the 6% to 20% investment range (63% of respondents), with few (4%) allocated more than 40%. It is understandable that advisors aren't as comfortable as institutions with having large portions of their clients' portfolios in alternatives. Many clients haven't had access to alternative strategies until recently (when alternative mutual funds proliferated), and alternative investments are difficult to explain to clients.

Hot-Topic Responses
This year's hot-topic questions addressed a variety of issues. One of the issues was hedge fund gates. These fine-print provisions that allow hedge fund managers to renege on their stated liquidity terms cause 36% of institutions and 26% of advisors to be somewhat more reluctant to invest in hedge funds. Only 22% of institutions and 10% of advisors (per the survey) are not deterred by gates. One advisor acknowledged that even though his research team may be willing to accept gates in some instances, his clients are not.

On the topic of managed-futures mutual funds' ability to charge performance fees, the majority of respondents (58% of institutions and 67% of advisors) indicated that the group shouldn't be allowed to charge performance fees. But investors were highly concerned over fee transparency. Many managed-futures mutual funds underwent a transparency crisis in early 2013, when the use of total return swaps to gain access to subadvisors allowed their fees (management and performance fees) to be removed from expense ratios. Per the survey, 86% of institutions and 89% of advisors thought that the fees should be included in the expense ratio.

In terms of accessing alternatives through exchange-traded funds, 56% of institutions and 72% of advisors responded that they would consider these vehicles, as more actively managed alternative strategies are becoming available in ETFs. One advisor pointed out that alternatives are generally not tax-efficient, while ETFs are. An alternative ETF could marry the best of both worlds.