Wealth Advisors Broaden Offerings To Include Hedge Funds

By Douglas Nelson and Michael DeJarnette, ConvergEx Prime Services — The world of alternative investment products is always changing. Sometimes the changes are dramatic and sometimes they are subtle. A seemingly subtle change is a recent trend involving independent wealth advisors entering the alternative investment space.

Douglas NelsonMany observers believe this entry into the world of hedge funds by a group of advisors that has a reputation for being more conservative is the beginning of a significant trend. Wealth advisors have a “captive” audience of accredited investors to present the pooled products to in hopes of transitioning assets to what they see as a more efficient means of providing hedged or leveraged strategies. Many advisors and other independent asset managers want to utilize limited partnership structures to give their current clients and potential new investors the ability to participate in strategies that take advantage of bear markets, uncertainty and market volatility – the idea being that they are able to use the pooled nature of that structure to streamline the process of implementing more complex strategies over a broad group of clients. They are also able to potentially broaden their client base to include more sophisticated families and individuals.

Michael DeJarnetteOver the last 12 to 18 months, there has been a notable increase in the number of wealth advisors creating pooled investment vehicles such as hedge funds in order to implement hedging strategies. The move is a response to the volatile and sideways markets that we have seen over the last decade, which in turn has created demand for these products from a wealth advisor’s existing clients.

The majority of these strategies are executed within limited partnership structures – typical of the classic hedge fund. A wealth advisor may have a sophisticated hedging or volatility capturing strategy that has a proven track record, however the securities and instruments required to execute the strategy may be prohibited on a typical advisor platform. If that is the case, the manager is restricted in the use of the strategy unless the end client has an account that is large enough to be held in custody at an institutional broker dealer. This may exclude sophisticated, accredited investors from having a protective collar or some other hedging strategy implemented on his or her behalf. A pooled investment such as a hedge fund may allow this client to take advantage of a strategy that would otherwise be out of reach. The continued uncertainty of global markets appears to be accelerating this activity.

Business Model Aimed At Retaining Clients

Wealth advisors come in many forms. There are traditional registered investment advisors that may have hundreds of individual accounts ranging from small IRA accounts belonging to the children of longtime clients to large family trusts. Multi-family offices may also fall into this category as well as independent financial planning practices. Not all of the end clients of these advisors would be sophisticated enough or even have interest in options, futures, long/short equity, or other alternative strategies.

There are, however, subsets of these investors that have a desire and a need for alternative products in their portfolios. Some wealth advisors bridge this gap by investing in alternative mutual funds or hedge funds that are approved on certain advisor solutions platforms. There are good choices, but an advisor may still believe that his or her clients need a more customized solution or they may simply feel that they can better serve their clients by using a proprietary strategy or choosing managers from a larger universe.

A hedge fund structure can accomplish this goal by allowing the advisor to allocate the funds of clients who wish to invest into an actively managed hedge fund that can protect against or take advantage of market volatility. Other advisors may hire sub advisors to manage these products. That allows for control of the hedge funds management and strategy but outsources some of the infrastructure and cost.

Another method of implementing a hedge fund vehicle is to use a “fund of funds” type strategy. The wealth advisor can create a limited partnership that invests in other hedge funds. This allows far more customization and diversification than the advisor platforms allow. Some advisors create several hedge fund products with differing strategies to allow for asset allocation. One strategy may be fixed income and others may be options, long/short equity, futures or any number of other alternatives. Investors can allocate to these partnerships on a percentage basis based on portfolio goals.

Sophisticated clients often want exposure to alternative investments in their portfolio and wealth advisors want to make sure that client assets stay within the firm. Wealth advisors are looking to broaden their product offering to include alternative investments and are looking to their existing client base to market their new funds. If the advisor doesn’t offer viable alternative investment vehicles to accredited investors within their client base, these assets may go elsewhere. Hedge funds typically charge more to investors than classic wealth advisors, so the advisor may or may not charge higher incentive fees to existing clients.

If an advisor has a proven strategy that works well within the hedge fund structure, it can also allow for marketing outside of his or her current client base to higher net worth individuals and entities which is, of course, beneficial to the wealth advisory company. Many times there is not much outside money raised due to the fact that wealth advisors tend to take a longer term approach to their business and often spend more time seeking “clients” rather than “investors.”. It is a personal choice as to how to market the products.

Trends come and trends go, but this seems to be a business model that may make sense for the long term. Wealth advisors are typically in touch with a number of sophisticated, high-net-worth, accredited investors that have an interest in alternative products. It can be beneficial to the advisor as well as to the client if the one who knows them best is actively engaged in their entire portfolio. We see this as a trend that is here to stay.

Douglas M. Nelson is Chief Executive Officer of ConvergEx Prime Services, and Michael L. DeJarnette serves as President of ConvergEx Prime Services. The firm is dedicated to providing prime services to professional investors including hedge funds, family offices, mutual Funds, and registered investment advisors.