The debate rages on about whether alternative investments are a good idea. Some global money managers and strategists believe they are important for reducing overall portfolio risk. Others think they may add to risk, not just because of recent hedge fund scandals and blow-ups but also because of more universal market trends.

Peter O’Reilly, global money manager at I.G. Investment Man-agement Ltd. in Dublin, says alternative investments have proven to be good at diversifying portfolios and reducing risk. He notes some managed futures and managed currency funds have good track records, but warns that a lot of the equity-based alternative funds are just leveraged versions of what you can get in a traditional equity fund. Not surprising, given his enthusiasm for alternatives, one of O’Reilly’s biggest holdings is Britain-based Man Group PLC, a major global supplier of hedge funds.

Clancy Ethans, chief investment officer at Richardson Partners Financial Ltd. in Winnipeg, is also a big fan, pointing out that large institutions have done well with alternatives, and have as much as 60% of their assets in them. Individuals should have at least 5%, he says, because modern portfolio theory shows that adding asset classes that have little or no correlation with traditional stocks and bonds pushes the efficiency frontier up and to the left, he says. That means more return per unit of risk.

Richardson Partners has a private-equity fund for its retail clients to give them access to more alternatives than generally have been available in Canada, although this is changing. Toronto-based BluMont Capital Inc. expects to launch a retail private equity fund soon that will be broadly available, and plans to add a retail real estate fund later this year.

Jean-Guy Desjardins, president of Fiera YMG Capital Inc. in Montreal, also thinks alternatives are a good idea but says you have to be careful because there are so many types: “You should add them only if they reduce risk to traditional financial markets and improve your expected return.”

History is short in this area, he adds, and you could end up with unpleasant surprises. He favours market-neutral strategies, in which you eliminate market volatility, absolute return strategies and investing in infrastructure (the last of which is not yet available in Canada).

His most important advice: make sure you use highly competent professionals that know how to manage risk.

Clement Gignac, chief economist and strategist at National Bank Financial Ltd. in Montreal, is not enthusiastic. With the amount of money pouring into hedge funds, he suspects that there’s a shift from “alpha” to “beta.” That is, there is less added value coming from managers’ skill and more from market performance. He doesn’t like the risk and thinks most retail investors are not fully aware of the risks they may be running. He’s also nervous about the lack of his-tory, which means we don’t know how hedge funds will behave in a major market crash. And he points out that with risk premiums low in emerging markets and high-yield debt, there are fewer “mispricings” and anomalies for managers to take advantage.

Leo de Bever, chief investment officer at Victorian Funds Management Corp. in Australia (for many years, he was with Ontario Teachers’ Pension Plan Board, which makes extensive use of alternatives) is even more negative: “The market is in a frenzy now. Retail costs are too high to lead to a sustainable advantage over low-cost exposure to stocks and bonds. And even for institutional investors, the pickings may be slim. There are too many dollars and fund managers chasing too few good opportunities.”

Steve Kangas, president of BluMont, acknowledges the negative feelings about hedge funds. But he still believes products with long track records, such as the BluMont Man notes, can be appealing to retail investors, as are simple strategies such as long/short equity investing strategies like those offered in BluMont funds.

Nevertheless, Kangas believes it’s a good time to be broadening the basket of alternatives by offering private equity and real estate funds. BluMont can use the expertise of parent Integrated Asset Management Corp. , which offers private equity and real estate vehicles to institutional clients, along with private corporate debt and managed futures. BluMont already uses IAM’s expertise in managed futures in some of its multi-strategy funds, and will soon launch a fund that is solely managed futures.

@page_break@Retail clients should be thinking about all kinds of alternatives, says Kangas: “You constantly see reports about another private-equity firm taking over a public company. Bigger and bigger firms are being bought.”

The problem with both private equity and real estate is liquidity, because these are long-term investments offered in closed-end funds, with the money typically locked up for 10 years. Retail clients shouldn’t have money in these investments that they may need in the interval.

Jim McGovern, president of Toronto-based Arrow Hedge Partners Inc. , remains upbeat on the hedge fund world. “Every day, pension and endowment funds find ways to incorporate or boost their exposure to alternatives,” he says.

McGovern thinks retail clients should have 10%-15% alternatives in their portfolios — a mix of hedge funds, as well as exposure to real estate and commodities such as energy and precious metals. Investors could go as high as 20%-25%, depending on their sophistication and age and the amount of assets involved, he says. The older investors get, the more they should have because alternatives reduce risk.

The key to success in alternative investing is the quality of the people managing the investments, according to McGovern: “You aren’t buying a strategy or market; you are buying a manager.” But even with the best people, he cautions: “You have to keep on top of them, follow what they are doing and make sure they stick to what they said they were going to do.”

There have been too many cases in which good managers strayed or took very big bets that increased risk.

McGovern suggests retail inves-tors start with a fund of hedge funds to get their feet wet. These funds are more diversified and have less risk. Once investors are comfortable, they can add some single-manager funds but still should have at least two core funds of funds. IE