Freedom from market swings: the case for alternative investments.

EXECUTIVE SUMMARY

* THE OBJECTIVE OF ANY INVESTMENT STRATEGY CPAs recommend to clients should be to preserve capital and build on it at a consistent rate in both bull and bear markets. The key to doing this is to look beyond stocks and diversify into alternative investments.

* A PORTFOLIO CONSISTING ENTIRELY OF STOCKS is at the mercy of the market. When the Dow or Nasdaq drops, the portfolio drops. CPAs need to help clients pursue an asset allocation strategy that is not wholly correlated to the stock market. That means taking long and short positions on stocks and bonds and diversifying into mortgage-backed securities, distressed securities, convertible arbitrage and other financial instruments.

* USING ALTERNATIVE SECURITIES TARGETS A DIFFERENT outcome steady gains and wealth preservation, year in and year out, through up and down markets. Hedge funds are an efficient way to diversify into alternative investments.

* A HEDGE FUND IS AN INVESTMENT PARTNERSHIP that seeks to balance its risks by "hedging" long positions in some stocks with short sales of others. Most hedge funds enable investors to realize moderate gains no matter how the stock market is doing.

* USING A FUND-OF-FUNDS APPROACH CAN MAKE it easier for smaller investors to invest in hedge funds, which often have minimum investments of $5 million or more. A fund of funds is a private investment partnership that invests in multiple hedge funds. It offers clients access to hedge funds that would otherwise be closed to them.

An acquaintance recently lamented that her portfolio--consisting almost entirely of stocks--lost 40% of its value in the latter half of 2001. Her complaint is a common one these days. And, like many in her situation, she's taking a fatalistic approach. "What can I do?" she says. "Everyone's losing money in this market. But I'm not worried--I've got 10 years to make it back".

Unfortunately, she's wrong on both counts. Losing money in any market is neither inevitable nor universal. And short-term losses can have a devastating and long-lasting impact if the money isn't available when needed--to meet unexpected medical expenses or to take advantage of a business opportunity, for example.

The primary objective of any investment strategy CPAs recommend to their clients should be to preserve capital and build on it at a consistent, moderate rate in both bull and bear markets. Every investor has the means to achieve this objective within his or her grasp. The key is to look beyond stocks and diversify with alternative investments and strategies: hedge funds--first and foremost--as well as managed futures, private equity investments and real estate investment trusts. Here's how CPAs can help their clients do just that.

THE LONG WAY AROUND

Alternative investing isn't intended to disparage equity investments--only to argue for a more balanced and expansive view of them. The plain truth is that a portfolio consisting exclusively of "long" positions in stocks (no borrowed or "short" holdings) is wholly at the mercy of the stock market. When the Dow Jones industrial average or the Nasdaq drops, the portfolio drops; the only thing investors can do is hang on and ride it out.

As in the case of the woman described above, the collapse of stock values that had inflated to the size of hot-air balloons caught millions of investors off guard. Annual returns on the S&P 500 averaged 18% during the 1990s, topping 20% each year in the latter half of the decade, lulling many CPAs and clients into believing the good times would last forever. In those heady times, it was almost impossible not to make money. Everyone was a financial genius--or so it seemed. The following year, the S&P lost 9%.

In point of fact, the explosive growth of online trading and discount brokers turned a whole generation of individual investors into Wall Street traders. But moving in and out of positions based on stock quotes read off a cell-phone-display panel isn't investing. It's Las Vegas.

ALL BETS ARE OFF

Gambling is risky; investing shouldn't be. Thus, the first step a CPA can take is to point clients in the direction of specialized investment advisers who can help them pursue asset allocation strategies that aren't wholly correlated to the stock market. That means taking both short and long positions on stocks and bonds (including high-yield issues), as well as diversifying into mortgage-backed securities, distressed securities, convertible arbitrage (buying a convertible security and selling short the underlying common stock) and other financial instruments. It's the way fiduciaries, institutions, bulge-bracket firms (the most elite investment banks) and wealthy individuals that are determined to stay wealthy invest.

If this sounds like a replay of the old saw about not putting all your eggs in one basket, it is--and it isn't. Asset allocation has been around for some time, but many think the concept simply means spreading risk among several stocks. Some investors move in and out of positions according to the vagaries of the market or a broker's hot tip; others follow a buy-and-hold strategy, knowing that a temporary drop in share price is no reason to abandon a solid company. "I believe in Hewlett-Packard," they say, even as its stock price shrinks by 50%. Both approaches result in a portfolio doomed to move in lockstep with the stock market. Both are antithetical to the notion of wealth preservation. And both have little to do with true diversification, which implies making investments across sectors, asset classes and strategies.

Other investors attempt to "time the market," which is about as easy as timing a Roger Clemens fastball and no less futile. All evidence suggests timing techniques simply don't work, notwithstanding those who claim they're successful at least some of the time. (Even a broken clock is right twice a day.) Some investors carefully research companies to determine where to put their money. Information--vast stores of it--is readily available on the Internet. But without the means to evaluate, interpret and put it into perspective, it's of little value. As economist Frank Knight observed, "Because the economic environment is constantly changing, all economic data are specific to their own time period, and consequently they provide only frail data for generalizations."

UNCONVENTIONAL WISDOM

Half a century ago, a University of Chicago graduate student named Harry Markowitz advanced a novel perspective on investing. Predictability was a good thing, he suggested in a landmark paper published in 1952; risk was not. To minimize risk without sacrificing returns, choose investments according to how they interact and not the stand-alone performance of each. Determine a reasonable rate of return, he advised; then compose your portfolio to yield that return with the least possible risk.

Markowitz's views ran counter to conventional thinking, which favored singling out the most promising investments and betting the farm on them. "A rule of behavior which does not imply the superiority of diversification must be rejected," he wrote. His ideas became the foundation of modern portfolio theory (MPT), for which he shared the 1990 Nobel Memorial Prize in Economics.

MPT allows for the fact that financial markets are by their nature unpredictable. An infinite array of events that are impossible to foresee or control affect returns--currency meltdowns, earthquakes, terrorist attacks and 100-year storms (which have a way of occurring every five years). Logic and rational thinking rarely factor into the mix. As we saw in the dot-com era, a company's underlying strength, reflected by such variables as profitability, earnings prospects and market share, may have far less effect on share price than mindless exuberance. How else can we account for the swings and gyrations in the stock market in recent years? Between October 1998 and March 2000, the Nasdaq soared from 1,400 to 5,100, then plunged to 1,650 in April 2001. Through it all, a lot of people clung to their belief in the "efficient market." From where I sit right now, the term is an oxymoron.

DON'T TRY THIS AT HOME

CPAs will find the use of alternative securities takes the investor out of an unwinnable game and targets a different outcome altogether--steady gains and wealth preservation, year in and year out, through up and down markets. But building and managing a portfolio geared toward that objective isn't simply a matter of spreading risk among multiple investments. True diversification requires specialized expertise across the full spectrum of alternative investments, as well as advanced quantitative models. CPAs will find that attempting to do it unaided is a bit like trying to remove your own appendix. Professional management is usually in order.

Indeed, it wasn't even possible to put Markowitz's theories into practice much before the 1980s, when computers first allowed high-speed data processing. Until then, asset allocation typically meant buying a bunch of blue chip stocks and sitting on them, come what may. It seemed like a good idea at the time, until 1973 to 1974, when the so-called nifty 50--a group of top-performing "must own" stocks--plunged to half its value.

Hedge funds represent one of the most efficient ways to diversify into alternative investments. A hedge fund is an investment partnership that seeks to balance its risks by "hedging" long positions in some stocks with short sales of others. Most are set up as private partnerships or as offshore investment corporations. They employ leverage, invest in many markets and come in a bewildering variety of shapes, styles and specialties.

Myths and misconceptions about hedge funds abound. Among the most pervasive is that they are by definition unduly risky. To be sure, some are; the 1998 collapse of Long Term Capital Management and its bailout by the Federal Reserve made headlines around the world and no doubt scared off many potential hedge fund investors. Not surprisingly, many people generalized from the specific, erroneously assuming all hedge funds are dangerously overleveraged and on the verge of imploding. This is not so--although some caveats do apply. Hedge funds remain largely unregulated; at least some of the 4,000 funds currently in operation are run by managers with little or no experience in down markets. And fraud is not unheard of.

UPSIDE POTENTIAL 

The good news for CPAs and their clients is that most hedge funds are run by experienced managers whose goal is to minimize risk--not overdose on it. Consequently, the funds enable investors to realize moderate gains, year after year, no matter how the stock market performs. Traditionally viewed as the exclusive preserve of the superwealthy, hedge funds have attracted a broader following in recent years; many top-tier universities have invested upwards of 20% of their assets in them. Well-run hedge funds aren't aimed at making their members wealthy, but at keeping them wealthy.

On the face of it, high minimum-investment requirements would seem to put most hedge funds beyond the reach of most clients. But there is a more affordable way: a fund of funds. This is a private investment partnership that invests in multiple hedge funds. By aggregating pools of investor capital, the fund-of-funds manager can easily meet minimum investment thresholds of $5 million and higher; meanwhile, individual investors can participate for a comparatively low $250,000. (Hedge funds operated by mutual fund families may have even lower minimum investment requirements.)

CPAs will see other pluses to this approach as well: A properly balanced fund of funds provides broad diversification across asset classes and blended rates of risk and return. It offers clients access to hedge funds that would otherwise be closed to them. And its design optimizes the correlation among the component funds. This means that when some funds are in decline, others are gaining value. A fund of funds can thus make it possible for clients to reap the full rewards of asset diversification, widely likened to "the nearest thing to a free lunch."

At the risk of overstating the case, there is a price to pay. To protect wealth and make money in all markets, clients must view investing in a systematic, intellectual framework rather than as a matter of reacting to phone calls from brokers and brothers-in-law with hot tips. Perhaps even more difficult, investors must resist the seductive allure of unlimited earnings in favor of a more moderate but consistent rate of growth. During the 1990s, when it was easy to rack up gains of 20% to 40%, the returns on portfolios that weren't solely correlated to the stock market averaged only 10% to 14%. But in 2001, when "shoot for the stars" investors actually lost money in the stock market, diversified investors still made their 12% to 14%. Many are targeting comparable gains in 2002--even if the recession deepens. For CPAs advising clients on hedge fund investments, the key, of course, is in choosing funds managed by astute professionals with a high level of expertise, a consistent track record and a good understanding of alternative investments. (For more on hedge funds and their risks, see "The Hedge Fund Mystique" on page 55.)

A LITTLE CAUTION GOES A LONG WAY

The current interest in hedge funds, fund of funds and alternative investments owes much to the economic climate. But there is another driver. The investing public is taking an increasingly jaundiced view of Wall Street. Many are beginning to see it as little more than a grand casino--where speculation rules and many bets are rigged. Consider this: In more cases than not, the firm that underwrites a stock issue also produces the analysts' buy-and-sell recommendations where "sell" advisories are as rare as Ming vases. Whether the price is soaring or plummeting, the watchword invariably is "buy." For CPAs and clients who know better, a more cautious approach may yield better results.

The Uncertainty of the Stock Market

* Fewer than half of investors (49%) believe S&P 500 returns will be positive in 2002. Even fewer (44%) believe returns for the Nasdaq Composite Index will be positive this year.

* Only 16% of investors have reallocated or increased their investments in bonds because of the recent stock market volatility. Few have changed the amount they invest in mutual funds (21%) or in individual stocks (19%).

* Despite lower expectations, investors have not altered their investing style because of stock market losses. More say they are comfortable being momentum investors (42%) than taking a contrary approach (31%).

Source: Third Annual Investor Survey, Eaton Vance Corp., Boston, www.eatonvance.com.

WILLIAM LANDBERG, CPA, is a managing member of West End Financial Advisors, LLC, in White Plains, New York. His e-mail address is [e-mail].