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Why you should consider alternative assets in your clients' retirement portfolios, and how do you get paid for doing so?

• By Tom Anderson
• Tom's Blog
• 04.25.2008
• PENSCO Trust Company
• CEO & Founder
• San Francisco, CA

Note: This article is intended for financial advisors, however, many may find this article of interest.

You can save quite a bit of time on this topic by simply accepting the value assumption that the inclusion of alternative assets in client portfolios will, on average, improve the portfolios' performance over time. I don't need to do more than to invoke Harry Markowitz' name and his modern portfolio theory to substantiate this assumption, however, I'd like to offer some empirical evidence for those not easily swayed. If the assumption is anathema to you, there is no need to read further. But first...

How do you get paid?

Maybe you're thinking that helping your clients diversify outside of the stock market sounds good, but how can you incorporate some of the non-traditional asset classes into your clients' portfolios and still be paid and get approval from your broker-dealer? Well, let's break that compound question down into two parts and then address each separately. First, on the "how do I get paid", if you are an Registered Investment Advisor (RIA), you can charge financial planning fees for your services in defining your clients asset allocations based on their goals, risk tolerance, and stage in life. Furthermore, incorporating alternative asset classes makes intuitive sense and is backed up by the un-refuted Modern Portfolio Theory.

So what's the catch? Usually, the problem is with the second half of the compound question. That is, how to you get your broker-dealer to go along. My first answer to that is that if you are an independent RIA and not tied to a particular broker-dealer through your Series 7, then there is no need to get approval. On the other hand, if you do not select the alternative investment for your client, you may need to charge less than you would for managed assets. I have heard that some advisers are considering taking a more active role in certain alternative asset investments (e.g., reviewing transactions for potential prohibited transactions or handling property management for real estate investments) and charging commensurate fees.

Secondly, it is not illegal, and many broker-dealers are starting to consider allowing their advisors to go independent (rather than lose them to a firm that will) so they can keep their traded business, or are simply permitting them to diversify their clients' portfolios into non-traded assets. However, be forewarned that they tend to be very restrictive as to what they will allow and will generally limit choices to Reg D offerings, LLCs, "friends and family" private placements and not much more.

Are they happy about it? No. First, they don't get paid as much because they won't get their share of commissions on those assets, yet they assume certain risk exposure because you are their representative. If the investment goes south, they face potential legal threats and liability. They are especially uncomfortable because they are relying on you to do the due diligence, for the most part, on alternative investments. They have a point. Some will still ask you to submit your alternative investment for review before proceeding. Some smaller broker-dealers are actually setting up new entities so that they can delve into alternative asset classes directly and more aggressively without facing the issues of incorporating them within entities they don't control. If you disclose to your broker-dealer that you are creating a separate business that focuses on alternatives, their concern may relax somewhat, although they may still be concerned about "selling away". If you overcome that, you are off and running.

Some advisors will charge lower fees on those investments that they don't select for their clients, but incorporate into the clients' portfolios based on their view of appropriate asset allocations. Others might actually select and "broker" the real estate investments through a separately organized subsidiary that is licensed to sell real estate. One broker-dealer CEO from Boston , Massachusetts , realized the business potential of expanding into alternative asset management and decided to pursue doing so through his RIA entity. However, in his case, he reviews every alternative investment and is only gradually expanding the scope of investments he will permit his advisors to offer.

But the bottom line is that if you are interested or your clients are forcing you to consider alternative asset investments, you need to look into doing so directly with your broker- dealer or through some other means. "Alternatives" are not going away, and more and more consumers know about them. PENSCO Trust's entire business is administering alternative asset investments in self-directed IRAs and our business has been growing in excess of 50% a year for the last five years due the baby boomers' interest in alternatives to traditional markets.

So what's your action plan?

Think about the following if you're an independent RIA:

If you have your Series 7 and are a representative of a broker-dealer:

Again, for emphasis, if this all sounds interesting, don't forget to consult your clients before investing your time and energy. It my belief, however, that many investors (especially high-net worth investors), are becoming much more informed and interested in alternative investment opportunities. But the fact that is important is whether your clients and target markets will respond to expanded investment choices. We all know that boomers are realizing the need to keep their portfolios growing as they believe they'll be around a lot longer than their parents. And they are concerned about outliving their money. Even professional organizations like the North American Actuarial Council (NAAC) are getting concerned as reflected in their April 23 , 2008 letter to Washington . Fifteen presidents of actuarial associations stated that the Washington-based American Actuarial Association should try to put the implications of increasing longevity into "the forefront of public policy discourse, to draw more attention to American's increasing lifespan because failure to do so could threaten the viability of many financial security arrangements."

So if your clients and prospects feel the same, why not investigate how you can meet their needs and get paid at the same time? Otherwise you may see your clients reduce assets under your management as they explore alternatives elsewhere.

The case for alternative assets

We all know that the largest portion of U.S. wealth is held by Americans who are either currently approaching retirement or who are already retired. Much of this wealth is concentrated in the owners' retirement accounts, as it has been accumulated over their many years of employment. Unfortunately, due to industry practice, this portion of Americans' wealth is drastically under-diversified. Approximately 96% of retirement portfolios are limited to traditional market investments, and although the incorporation of alternative assets is increasing, it is far from matching its proportional share of most American's taxable portfolios. As result, retirement portfolios (where the money is) are very vulnerable to market or "systematic" risk, which, if dramatic, can wipe out an individual's savings (e.g., Enron pension plan). More consideration, therefore, needs to be given by advisors to balance their clients' retirement portfolios by incorporating alternative and non-correlated asset classes to hedge against market risk.

Consider if you will the performance of the Yale Endowment fund. In a letter addressed to the members of the U.S. Senate Finance Committee on March 5, 2008, Mr. Richard Levin, President of Yale said "Yale's endowment today is the product of the generosity of our donors and thoughtful investment strategies and management of spending over the years, including during more trying times . Between 1968 and 1982 the value of the endowment fell to $2.07 billion from $4.07 billion (in 2007 dollars) as a result of weak investment performance and payout policies that were insufficient to preserve real value. More recently, Yale has benefited greatly from remarkable investment performance under newer strategies and revised payout policies, but future returns are uncertain."

What are the "newer strategies"? To quote M. Levin, "quantitative and qualitative studies of investment markets have led Yale to adopt a well-defined investment philosophy as a framework that provides a strong likelihood of consistent, high rates of return . Investing with an equity bias is the first tenet of Yale's investment philosophy . The goals of providing substantial resources to the operating budget and maintaining purchasing power of funds require investment in assets with high expected returns, principally equities, broadly defined. Returns from fixed income investments historically have been inadequate to support current needs . In addition, the University's vulnerability to inflation further directs the Endowment away from fixed income and toward equity instruments." Sounds good so far, but... "Unfortunately, higher expected returns from equities are accompanied by higher expected risks, with the potential for fluctuating Endowment values and spending levels."

Their solution? "The need to protect the portfolio against poor returns from a single asset class leads to the second tenet of endowment investment philosophy: diversification. Diversification reduces the expected variability of investment returns, as different asset classes are expected to respond to fundamental economic forces in varying ways. Diversification without the opportunity costs of investing in fixed income can be achieved by identifying high-return asset classes that are not highly correlated with domestic equity securities . Accordingly, Yale pursues investments in non-U.S. equities, real assets, private equity, and absolute return strategies . These asset classes provide equity-like returns in a pattern that differs from the return pattern of domestic equities, allowing the construction of a portfolio that offers both high returns and moderate risk. Disciplined implementation of asset allocation policy is an essential aspect of Yale's diversified investment approach.

So what asset allocations have worked for Yale? In 2005, only 20.9% of their Endowment fund was invested in U.S. equities, fixed income instruments and cash combined, a gradual decline from a high of 31.5% in 2001. The balance was invested in real assets, private equity, foreign equity and absolute return investments. From the period (1968-1982) when the Yale fund experienced the $2 billion loss, the fund has grown to over $17 billion, after reductions for operating expenses and the funding of scholarships for which it is primarily intended.

To quote a blog posting by Greg Retzloff on September 10th, 2007, "a September 7, 2007 Smart Money article by James B. Stewart, "A League of Their Own" looks at the superior returns and portfolio composition of the Harvard and Yale endowment funds."

Both the Harvard and Yale endowments have posted average annual returns of over 15% for the last decade. One key to their success has been a relatively low percentage devoted to U. S. stocks and bonds and a relatively large percentage devoted to both private equity instruments and absolute return instruments.

"The portfolios of the two are similar in composition, so I have taken the average of the two in each of these categories:"

"What is of real interest here is not the actual instruments in the portfolio, but the asset class percentages, their interaction with one another, and their reason for being there."

"The domestic and foreign positions are straightforward. The fixed income portion, aside from having relatively low volatility and risk, tends not to correlate well with the equity portions. The real asset category serves two functions: 1) as an inflation hedge, and 2) as a diversifier, helping to lower the volatility of the overall portfolio. TIPS, commodities, natural resources, and energy all tend to do well in anticipation of, and during, inflationary periods. The natural resource, commodity and energy groups tend to have a low correlation with the rest of the market. REITS also tend to move counter to the (direction) of the market. Private equity arrangements are pure return strategies. The absolute return category serves as a hedge against the up and down cycles of the balance of the portfolio. It usually involves long/short strategies."

"While unconventional by traditional individual portfolio standards, this portfolio is modern portfolio theory at work. By combining a number of relatively uncorrelated but high risk (and potentially, high return) assets together, the endowments can get the "free lunch" of modern portfolio theory--that is, potentially high return with relatively low risk. And what risk there is will be minimized even further by the long-term outlook of the endowments."

"Note that both Harvard and Yale have a lower standard deviation than the S & P 500" (9.65, 10.65, and 14.89 respectively)," but higher returns --less risk with more reward. This fact is reinforced in their Sharpe ratios. Both Harvard and Yale have higher risk-adjusted returns than the S&P 500 as measured by their higher Sharpe ratios" (1.18, and 1.23 respectively) versus the S&P at .65. "Thus, the modern portfolio theory "free lunch."

So, how did they do overall from the period from 1985 through 2007? The average annual return over the 22 year period was: Yale--17.14%,?Harvard--15.92%, and the? S& P 500--14.22. So there certainly appears to be some merit to their asset allocation approach.

Another related example can be found with State of California CalPERS , the largest American pension fund. CalPERS has grown tremendously to $250 billion from $208.3 billion since June of 2006, largely due to its asset allocation approach, which is very similar to Yale's in that the largest portion of the portfolio is composed of alternative asset investments. The CFO, Russell Read, who joined CalPERS at that time, and who is resigning effective this June, spearheaded the most radical shift in the pension fund's asset allocation in the past 10 years, raising its private equity and real estate allocations and putting half of its total investment portfolio into international markets. The system also created an inflation-linked asset class that includes investments in commodities, infrastructure, timber and inflation-linked bonds. Mr. Read also pushed for more green-friendly investments. CalPERS' new forest policy, approved in March of this year, allows managers to invest in the nascent carbon markets and cellulosic ethanol, a biofuel under development.

Want more evidence? An April 21, 2008, column by syndicated columnist Steve Butler, entitled "House beats stock market", is a correction for his previous week's article where he claimed the stock market outperformed the real estate. As a result "my email was sizzling on Monday morning thanks to several readers who pointed out that my math had failed to take leverage into consideration". "Look at ROI" screamed the readers. He then goes to correct his assumptions, concluding with: "Setting aside the recent self-destructive behavior in the mortgage industry, home ownership is a tremendous wealth-building tool. I was wrong last week". Well, in fact, if you are a real estate investor, the current mortgage crisis is creating opportunities that have not been seen for five years and that may not come again in ten -to buy low (real estate is currently on sale in many parts of the country and rents are high) hold, and sell high when the market comes back and supply and demand are in equilibrium. There are similar opportunities for real estate in many foreign countries as well where real estate is appreciating and economies are stronger.

With these retirement plan examples of the success with diversification "ala the Modern Portfolio approach", does it make any sense that other tax-exempt portfolios like IRAs are so under-diversified. I think not, which is why over $1.7 trillion was lost in these accounts during the 2000-2005 timeframe. In fact, all portfolios need similar diversification. Rather than concentrating losses in one portfolio, why not manage each portfolio for optimal gains? Does that mean you don't have to pay attention to dynamically changing events that can affect each asset class? Absolutely not. OAs I write, the prices of rice and many other food products (commodities) are rising and gold has appreciated to record highs over the past five years. It is also rumored that Bill and Warren (Gates and Buffet) are currently stocking up on gold as a safe haven. But to quote Jim Ostroff of Kiplinger's in an April 9, 2008 article "Commodities are way out of whack with the dynamics of supply and demand. The froth in oil, for example, accounts for about one-quarter of its current $108 a barrel price on the futures market. Copper is a good 35% above logical levels; platinum, 30%; tin, 50%; nickel, 25%; zinc, 20%; corn, 15% to 20%; and soybeans, 20%."

"What's behind the commodity bubble? Mainly investors chasing high returns. They're pouring cash into commodity futures because other choices seem less attractive. The Standard & Poor's 500 stock index lost 10% in the first quarter, its worst quarterly performance since 2002. Interest rates keep falling. Foreign producers of oil, metals and farm products want to keep prices high to offset the dollar's descent to record lows. And no one can guess when home prices might hit bottom and rebound."

"Commodity gains add to herd behavior. With every price spike, more investors jump in, afraid they'll miss the score of a lifetime." Nevertheless, "the bottom isn't going to fall out of the commodities market. Supplies are tight, and demand for many products will remain high, particularly with growth in China and elsewhere ."

Beyond commodities, precious metals, hedge funds, and real estate, there is always private equity. While this latter asset class represents the highest risk of all classes, it corresponding has the potential for astronomical gains, when founders and friends and family get into the first round of funding with stock prices at pennies on the dollar, and with the prospect of having return percentages in the 5 digit range. Of course, such investments should themselves be well diversified and represent a smaller percentage of the average portfolio, unless you're a founder, in which case you may want to risk more for your "baby"! But for your average client, a reasonable exposure to this asset class can bring a windfall, and losses than can be tolerated.

Other alternative asset types include, foreign equity, funds of funds, structured settlements, life settlements, oil and gas, and others, each of which has its own set of intricacies, advantages and disadvantages. The one thing they each have in common with the others, is that their success or failure has very little to do with that of the other classes. That is, they are not or negatively correlated . For example, the investment results for Chevron and United airlines will tend to be inversely related. Both are likely to be effected by the price of oil and fuel, but in directly opposite ways. A broader example can be seen when looking at the period from 1970 through 1980 during which there was extremely high inflation. Interest rates were rising from an extreme low to an extreme high, peaking around 1980. The cost of everything was rising during this time period. Commodities turned out to be terrific investments throughout this period, but stocks, bonds and real estate did not do well. Silver and Gold excelled as alternatives as gold peaked around 2300% higher than its low and silver peaked around 2700% higher than its low.

Pursuing these types of asset classes, however, will require you to study the nuances and/or to bring in experts from the respective fields. But, developing your knowledge and professional network of experts in these areas can help to differentiate you. Many custodians, like PENSCO Trust, will help educate for little or no cost. Furthermore, expanded investment choices will lead to more diversification that can further risk-protect your clients' portfolios from a sudden shift in a portfolio asset class that would otherwise dominate the client's portfolio. And, if you're fortunate, you may overachieve client portfolio performance, while your competition weathers a down market in traditional assets classes, much like we are currently experiencing.

After all, if you can improve investment performance for your clients, who are now more likely to live longer, you'll have happier and more financially secure clients that will stick with you pay you more in the long term. That has the extra benefit of helping you afford your own retirement!

The foregoing is a general discussion. It is not intended as, and may not be relied upon as, tax, legal, investment or other advice. Readers desiring such advice should consult their own advisors.