The Alternative Route

Following the success of alternative investments for institutional investors, advisers are increasingly using alternative investments in the retail market, Cerulli research says.

As some alternative investments—such as real estate investment trusts (REITs) and even exchange-traded funds (ETFs)—are becoming pretty familiar to advisers, other alternative strategies are not gaining as much traction in the adviser market, Cerulli data show.

The markets of late have reinforced the importance of diversification, therefore increasing consumer demand for alternative investments, according to the latest The Cerulli Edge—Adviser Edition. However, Cerulli says some advisers are using alternative investments more to generate revenue in a bear market than to complement to a client portfolio.

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Overall, the increased uptake of alternatives by advisers has increased as major foundations, endowments, and defined benefit plans have increasingly allocated to alternatives. About half of advisers surveyed by Cerulli say academic research and institutional investing has influenced their use of alternative investments. A much smaller number (15%) say client demand has influenced their use. The report says that as adviser and client comfort with alternative investments continue to grow, so will usage.

More products are flooding the alternative investment market, including ETFs and other products designed to increase diversification (see The Rising Fame of ETFs). Non-traded REITs are among the most common retail-sold alternatives (90% of advisers across all core markets use them). Because they have fairly low minimum investments, they are much more accessible to lower-net-worth clients than hedge funds. Most advisers (62%) say the main reason they use REITs is to diversify, according to Cerulli data.

Hedge funds are generally based in the high-net-worth market. Advisers who focus on clients with more than $10 million in net worth have around 10% of their assets in hedge funds, compared with no hedge fund assets among advisers focused on clients with a net worth less than $250,000, according to Cerulli. But Cerulli also sees a trend of young wirehouse advisers using hedge funds and other alternatives as a way to differentiate their practice. Across all markets, 40% of advisers implement hedge funds. In the $250,000 to $1 million core market, 19% of advisers use hedge funds, and that percentage gradually increases. In contrast, advisers in the under $250,000 market use no hedge funds at all.

Cerulli says fund of funds (FOFs) are the future for hedge funds in the retail channel. For retail investors with lower balances than a DB plan, FOFs provide diversification, giving access to more than one manager. Structured products are also alternative investment options for advisers. Although few advisers allocate assets to structured products (less than 1%), they are being applied across multiple channels, according to Cerulli.

Ultimatley, manufacturers and broker/dealer firms should take note that it will be adviser education that drives the use of alternative investments, according to the report.

The Rising Fame of ETFs

It certainly hasn’t happened yet, but Cerulli analysts say exchange-traded funds (ETFs) could rival mutual funds if they become widely adopted in defined contributions plans.

According the most recent The Cerulli Edge—Advisor Edition, the “final frontier’ for providers is the 401(k) market, which gave mutual funds their “household-name’ status. Some firms have already teamed up with recordkeepeers to offer platforms allowing block trading for participant accounts, mostly in the small to mid-size market.

Of course, there are many obstacles to ETFs experiencing wide adoption in the 401(k) arena (see Hard to Fit). Cerulli notes that the largest and most costly hurdles are technology and operations. ETF providers might be eager to enter the 401(k) market, but most do not want to become recordkeepers in the process, Cerulli says.

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“Without doubt, if ETFs end up on 401(k) platforms, more asset managers will look to enter the ETF space,’ according to the report. Consequently, adviser usage would increase as more investors became comfort with the products—much like mutual funds.

More Advisers Use ETFs

Although how ETFs will fit into 401(k) plans is yet to be seen, meanwhile, their uptake in retail accounts has been rapid. More than half (54%) of ETF assets are now held in retail accounts, according to Cerulli.

The adviser uptake of ETFs continues to rise as the number of fee-based advisers rise (see Advisers Report ETF Uptake). As many advisers no longer rely on commissions, they are free to look outside the mutual fund box. According to Cerulli, in 2002, 34% of advisers were fee-based, and ETF assets stood at $102 billion. At year-end 2007, both of those numbers were much higher: 54% of advisers were fee-based and ETF assets had grown to $613 billion.

The report describes your “typical ETF user’ as a fee-based adviser with high-net-worth clients, often working in a registered investment adviser (RIA) firm. Tax-sensitive high-net-worth clients with large balances outside of qualified plans are often a good fit for ETFs. Advisers outside of the prototype, however, are also using ETFs more.

Among advisers, RIAs are still the heaviest users of ETFs, with an average ETF allocation of 12%, compared with wirehouse advisers, who have an average 6% allocation. Cerulli calls the “elephant in the room’ the lack of revenue-sharing agreements with these vehicles. No ETF provider is participating in a revenue-sharing agreement, which is a significant source of income for large broker/dealers.

When it comes to how advisers use ETFs, Cerulli says it is often in the place of active products rather than index products. Advisers are continuing to find creative uses for ETFs, blending them with active products, using them alongside managed accounts, and building institutional-quality portfolios. According to the report, the primary reason advisers use ETFs is “diversification to stabilize portfolio returns’ (38%), followed by using ETFs as a core holding (29%). A quarter of advisers still say they have not used ETFs (25%). Much lower percentages of advisers use ETFs to generate income and alpha (4% for each).

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