Is your client seriously considering alternative products as a part of his or her overall asset mix?

The asset diversification that alternative products provide is important for minimizing risk and enhancing a portfolio’s long-term returns, says Clancy Ethans, chief investment officer at Winnipeg-based Richardson Partners Financial Ltd. This is based on modern portfolio theory, which holds that adding additional asset classes that are not — or are little — correlated with traditional stocks and bonds gives you more return per unit of risk.

Alternative products themselves are not necessarily low-risk, however. Indeed, many alternatives products use leverage, which increases risk. But the fact is they don’t move in lockstep with stocks and bonds, which increases the risk/return ratio of portfolios that contain all asset classes.

Institutions have been using alternatives with success for years. For example, 60% of the Yale University Foundation’s assets are in alternative products; that portfolio has one of the best track records in the world. Large Canadian pension plans such as those of the Ontario Teachers’ Pension Plan Board and the Ontario Municipal Employees Retirement System have also done well by investing substantially in alternative products, and the Canada Pension Plan Investment Board is following suit.

It makes sense for individuals to do the same, although not to the same extent. Most experts recommend 10%-20% of a portfolio be in alternative products. This is partly because individuals don’t have access to the array of alternatives that institutions use, such as private equity, real estate and infrastructure.

> Many hedge funds are available to retail investors with high annual income (in Ontario, $200,000 for an individual or $300,000 for a couple; it varies by province) and/or considerable financial assets ($1 million). The bulk of investors have less choice but enough to do the job.

> There is little access to private equity at the retail level. A few firms — Richardson and UBS Bank (Ca-nada) , for example — offer products to well-heeled retail clients.

> Investing in infrastructure projects is pretty much impossible for retail clients in Canada at this time

Increased access will come. For example, BluMont Capital Corp. in Toronto is considering launching private equity and real estate products that would be available to retail clients. But, for now, those clients are confined mainly to hedge funds.

Unfortunately, many advisors and investors view hedge funds as risky because of high-profile scandals involving Portus Alternative Asset Management Inc., Northshield Asset Management (Canada) Ltd. and Amaranth Advisors LLC.

But advisors and their clients shouldn’t shy away from the sector without examining what is out there. The key is finding suppliers with products both can understand and that they can trust to keep to their mandates and to pick and monitor outside managers carefully.

As an advisor, your first step is to be clear about what you expect the products to do. If you are looking primarily for enhanced returns, you have to face the fact that products that promise big returns are probably risky.

But if you want capital preservation, there are hedge funds that are designed to produce consistent long-run returns with drops in asset value kept to a minimum. “We will give up quite a bit on the upside to achieve that,” says Jim McGovern, president of Toronto-based Arrow Hedge Partners Inc.

UBS, which manages US$45 billion in hedge fund assets, is on the same page. “Using hedge funds is about preservation of capital, not about enhanced returns,” says client advisor Marco Di Girolamo. He also emphasizes that investors won’t get the benefit of hedge funds unless they hold them for at least five years or through a full business cycle. Each asset class has its own cycle, and it is only over time that the ups and downs of each asset class are offset by the movement of others.

Another factor to remember is liquidity. This is a particular issue with private equity and real estate because returns are lumpy and earned over long periods. But lack of liquidity can also apply to hedge fund-like products with a maturity date, as is the case with principal-protected notes. If a client needs to liquidate in a few years, liquid hedge funds are the way to go, says McGovern. Note that liquidity is often monthly (rather than daily, as for mutual funds).

@page_break@UBS believes multi-strategy, multi-manager funds of funds are the best way for investors to go because this virtually guarantees that there will be no blow-ups. In UBS’s core Global Alpha Strategy Fund, no manager manages more than 2% of the total assets.

UBS offers global hedge funds because, it says, the Canadian hedge fund industry is very small and investors are better off with well-diversified, multi-strategy, multi-manager hedge funds. UBS actively manages these funds by tilting the funds toward the strategies it believes currently have the best prospects and by changing managers frequently. Average annual manager turnover is 30%.

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Canadians who aren’t clients of firms that offer global hedge funds can get access to similar global products through funds such as BluMont Man closed-end principal-protected structured notes, which are RRSP-eligible, multi-strategy, multi-manager funds of funds overseen by British-based Man Group PLC requiring a $5,000 minimum investment.

Arrow has an open-ended global long/short fund with a $25,000 minimum investment that is RRSP-eligible, as well as RRSP-eligible, closed-end principal-guaranteed notes utilizing global managers and strategies for a minimum investment of $5,000.

There are also good Canadian hedge fund managers. BluMont, for example, is using hedge fund managers Hillsdale In-vestment Management Inc. in Toronto, Salida Capital Corp. in Toronto and Vertex One Asset Management Inc. in Vancouver, as well as its own managers in its new offering.

If clients are considering alternative products, they should include them in the non-registered portion of their portfolio. Most alternative products don’t generate income although they may have capital appreciation, which tends to be taxed as capital gains.

Because the focus is on capital preservation, use of alternative products becomes more important as clients age. Suzanne Alexandor, special solutions advisor at UBS, says even a client who doesn’t want any equity should have some hedge funds because good ones will lower the portfolio’s volatility below that of fixed-income. She suggests 10%-15%, depending on how much income generation the client requires. The client won’t be getting income from the hedge fund portion.

Arrow’s McGovern suggests focusing on multi-strategy, multi-manager funds but not lowering the amount of alternative products when clients are nearing or in retirement. He suggests an allocation of up to half a client’s equity, but no more than 20% of the portfolio.

UBS also offers UBS Dynamic Alpha Fund. This is not a hedge fund — although it can short both securities and markets — but a portfolio designed and managed to deliver similar reductions in volatility and downside risk. It’s a global fund with no Canadian content, but it’s fully hedged into Canadian dollars for Canadian clients. It generates income of about 5% a year. IE