A down market would do this.  That is, bring out a debate on the benefits of hedge fund-like investing.  With indexing and ETFs, one would think it’s all about gaining exposure to markets (hopefully on the upside) and reducing or eliminating exposure when required as a defensive measure.  You can call that effectively tweaking the asset mix or full out market timing.

However, today’s ETF industry is one that has evolved.  With inverse ETFs, any investor can now literally “build their own hedge fund”.  Shorting and the use of options requires a margin account which is not a big deal but now as long as one can open a trading account of the most basic kind, there’s not much to it to gain short exposure.
So this brings me to an email I received today care of Google Alerts which is a pretty amazing service.  You can basically tell Google to email you when anything new appears on the web related to a specific search.  Of course, for this blog something like “ETF” and “exchange traded fund” would do it.  The bad side to the service is you can easily have a big pile of emails in your inbox.

Anyway, here’s what I received today:

So on one side we have Bill Schmick and the other is John Bogle, the latter care of Tom Lydon at ETF Trends.  With Schmick and Bogle, it seems more appropriate to consider this debate as David and Goliath.  Although I understand Bogle’s comments regarding the newly filed Direxion ETFs with 300% market exposure, let’s be real … their appeal will be limited.  There will be no domino effect with new or existing ETF providers following up with leverage of 400% or higher.  If by chance they do, shame!  I’m certain market forces will simply laugh such products off the street.  Let me be clear:  Investors of all types will generally pass on Direxion or anyone else who goes down the path of even higher leverage than what we seen in the ETF marketplace today.

Is there demand for extreme leverage?  Of course.  Hedge funds play this game all the time.  Part of the basic reasoning is simply to juice the returns of strategies that don’t have the same bang they once did (crowded markets).  But these market participants use the derivative markets where they can better fine tune their required exposures, not simply some multiple of 100.  And of course, we know the difference between the returns provided from futures markets compared to the “daily return” limitation of levered/inverse ETFs.  Truly sophisticated investors will understand when to use levered/inverse ETFs and when to go to the futures market, swap market or other market for their required exposure needs.  So Bogle’s worries about extreme levered ETFs, I believe are in themselves, extreme.

Schmick on the other hand seems quite reasonable in his comments.  Unlike Bogle who might find some degree of the sector ETF universe unnecessary, I would side with Schmick on the benefits of sector ETFs for defensive strategies.  It’s unclear what Bogle would deem as “reasonable” as opposed to “absurd” in sector ETFs but I’d guess that the lineup from HealthShares would be the example given for the latter.  Since assets in this family of ETFs is relatively small, the point is moot.  But whether it’s the exposures provided by HealthShares ETFs or other rather new and esoteric areas like nanotech or cleantech, there are many reasons why investors implement sector based exposures, defensive or otherwise.  I wouldn’t want to take that away from them.  Market forces will take away the undesirables as required.

To reiterate what I’ve said many times before: In today’s highly correlation markets, diversification is the first line of defense but can only get you so far in addition to shifting the asset mix to increased cash holdings when markets decline for a prolonged period.  Sector rotation is one of the few defensive strategies left to investors.  The use of put options as an insurance policy to be bought in extreme up markets is another good one.  The use of inverse ETFs to join in on the momentum on the downside thereafter is good as well.  It would seem that the most classic of index/ETF proponents would want to stick with the strict buy-hold, rigid asset allocation philosphy which is fine.  But not for everyone.

A tough stomach is required in times of distress.  I’d hope that in today’s market (not meant to mean short-term oriented “today”), investors do not make rash decisions and completely overhaul their game plan.  My cynical views on active management and hedge fund performance still lead me to believe that there’s something to be learned from Bogle and those in his camp including not just Vanguard but DFA.  However, I think that investors, either with or without financial counsel, should consider what degree of non buy-hold thinking applies to their portfolio.  How much deviation from the policy asset mix should be allowed?  What alternative asset classes and strategies should be considered if any, and at what price?

The risk, as I see it, is that much of the most classical portfolio theories and methods we read in textbooks are based on a time when we didn’t have all the information or the tools to properly handle the information.  Today it’s different.  Sure, we have the tools to compute with greater speed and power than the early days of Markowitz and Sharpe.  These tools can even fit in a thin letter size envelope.  But despite all the information out there, it’s tough to manage it effectively so as to lead to a more thoughtful, elegant and even effective portfolio.  Until ETFs came around.
Maybe the new “active management” of investing does not revolve around picking managers but allocating among beta exposures.  That’s what institutions like CalPERS are doing by internalizing passive mandates (by first reducing active exposures where there’s more beta than alpha to be had).  I’m not trying to lead this thought to the “All ETF portfolio” but something rather close to this, with a healthy balance of traditional and alternative exposures, access to developed and developing markets, customized for income requirements and volatility tolerances.  Clearly, this thought process would seem to be elegant and “true to form” as just described if implemented mainly through ETFs and similar instruments.  15-20 positions might seem like a lot but without passive exposures, a more traditional “old school” portfolio built under the same premises would likely hold a couple of hundred securities at a minimum.  I’m assuming that someone who wanted some inflation indexed bond exposure wouldn’t just buy one bond.  Same with emerging market equities.  Or US small cap.  Or REITs.  Or even non-ETF related possibilities like hedge fund … well, maybe if it was a fund-of-funds but for some investors, even one of these might not be enough.

In my previous blog post (whoa … two posts in one week … easy there), I focused my attention on diversification.  That’s definitely what ETFs are about despite all the recent product development on narrow sectors and relatively small countries.  But ETFs are first and foremost about innovation.  This is good because it gives anyone access to ideas (water as an asset class), new regions (frontier markets) and a wide variety of capital markets that may not be as easy (logistically, cost wise, etc.) for many investors to reach.  This is also bad because the risk is that the ETF industry focuses too much on ideas rather than the true economic need for capital to be allocated in that “idea”.  I don’t see the ETF industry going down this latter path similar to the dot-com craze however, as in everything, a healthy balance is all that’s required.  Somewhere between Schmick and Bogle - they likely aren’t even the extremes on the spectrum - is the right balance for each and every investor.  Dictating what’s right and what’s wrong, limiting choice by not allowing for certain products (ETFs, hedge funds or whatever) and thus not allowing investors to choose where they lie on that spectrum in NOT the answer.  ETFs provide choice by allowing access in a meaningful and efficient manner.  The allowance for choice will be dictated by the user as in any market.

I keep telling myself, and the occasional inquirer, that I’ll get back into serious blogging … or at least publish at a pace similar to when I started back in 2006. Clearly, you will have noticed that that ain’t happening. One of the things that has kept me busier in recent times has been conference speaking. Just earlier this May I was at Connex International’s Public & Private Wealth Group Forum, an institutionally focused event with both a pension track as well as an endowment/foundation track.

To no surprise, there was a lot of content revolving around the use of alternative investments of all sorts but especially hedge funds. I was most interested in discussions related to emerging markets as, to me at least, it seems like this is an area where in the longer term there would be a fair assumption for double digit returns unlike other broad asset classes and strategies. The downside of course is the volatility but for long-term oriented institutions, that shouldn’t be a problem given appropriate diversification and risk budgets. However, the overall sense I had from this and other events in recent months was that emerging market investing is still in the early “toe dipping” stage. Never a good time to get in like when it’s nearly too late! I think it’s far from too late … in fact I think it’s still relatively early. But it’s this herd mentality that I believe is hampering the performance of many institutions. Perhaps the people working at conservative institutional funds just aren’t compensated in a way that would allow them to deviate from what would be perceived as “industry norms”.

Of course, the same could be said of the herd mentality of all investors including retail individuals and their financial advisors. What once was about picking stocks has now moved well past chasing managers with mutual funds to chasing markets via ETFs. Is Kang bashing ETFs?!!! Well, yeah in a way but everyone knows that the gold market and other peaky, speculative (pick an adjective) market has likely had its volatility juiced up due to the level of increased participation of everyday investors thanks to ETFs. Whether it’s good or bad is not for me or anyone to say … in any market that sees more speculators come in versus long-term investors it’s common to find more instruments to feed the frenzy. Remember all the tech and Nasdaq funds in 2000?

The whole concept of alternative investments is a bit of a conundrum to me. At the one end, it’s a reality that has to happen given the limitations of traditional investments. Having a vanilla portfolio of stocks, bonds and cash can only get you so far. So called “couch potato” portfolios sound good but when the markets are going against you, the tendency will be to take action at the very worst time. I didn’t even say that the action would be right or wrong; I’m just saying that the timing will likely be off. If the decisions of what to sell, what to buy, what to hold, whatever, are also off … well, no one does well in college or at their job by being a couch potato.

Correlations among asset classes and strategies remain high. The search for low correlated alternatives will evolve in time but this search for the next new market will persist. The frontier markets of today will be the emerging markets and then developed markets of the near future. Technology, high educational standards internationally and the globalization of economies and capital markets will see this transformation process increase pace exponentially.

The low yield environment of today is another reason alternatives are hot. The traditional fixed income market just isn’t enough. And that includes inflation adjusted bonds where we’ve recently seen the TIPS market hit some interesting numbers (zero).

If we’ve now entered something similar to the beginning of the decade (negative returns with low interest rates), then we’re back to the deadliest of combinations for pension plans and their asset/liability mismatch predicament. With low interest rates, the present value of their liabilities increase so that, on paper … well let’s just say, GULP. Not good. The honest knee jerk reaction from some along with, of course, thoughtful debate and consideration by many others will be to increase allocations to all sorts of alternative investments. It would surprise me immensely if hedge funds and real estate did not get the biggest chucks of these new allocations. My hope is that these alternatives, no matter what they are, provide a true “risk reduction” function for portfolios as opposed to simply a “return enhancement” function. I believe the period of early 2003 to mid 2007 was the time for thinking about return enhancement.

With regard to thinking about risk, I now refer you to three videos that were made immediately after an appearance I made in Las Vegas earlier in April. I was speaking on global investing at the 5th Annual Las Vegas Financial Advisor Symposium thanks to the organizers at InterShow and an invitation from the panel moderator and fellow blogger, Tom Lydon. FYI: Equally cool and insightful blogger, Roger Nusbaum, was also a panelist with me on stage. It’s clear that moving from a US-centric portfolio to one that is more international (with a significant dash of emerging market exposure) is key to improving risk adjusted returns for long-term investors. The concern is implementation and keeping intelligent diversification a key directive. Anyway, the evolution of ETF industry to active management, emerging markets exposure and risk management are the main topics from the three videos. Clicking on the still shots below will lead you to InterShow’s site and the videos [Sorry for having to make you leave this site and come back for each video but there was no allowance for me to embed the videos on my site … traffic matters].

Evolution in ETF Industry:

Emerging Markets:

Risk Versus Return:

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This blog was always meant to cover the wider theme of “beta” but due to the wide proliferation and exposure of exchange traded funds, the other big beta instrument, derivatives, was kept to the side. Truthfully, my past was always more focused on the use of derivatives but when I blogged about it, I had limited feedback. Very different with ETFs … when I wrote something about a unique ETF about to come to market, the Wall Street Journal called me up. You now know why I focus so much on ETFs.

But once in a while, another story pops up on the derivative side that’s too big to dismiss. I wish it were some new exposure (like carbon credits) but unfortunately, like hedge funds, the derivatives markets provides a spectacular blowup/debacle once in a while and like a collision on the freeway, everyone pauses to take a look. This time, it’s SocGen’s (Société Générale SA) turn. Facetious as that may sound, this graph from the WSJ gives a quick snapshot of past blowups back to the days of Nick Leeson and slightly beyond.

It seems that in time, we often see the latest blowup being outdone again and again.

For anyone who has taken a risk management course, these “rogue traders” and their blowup events are part of the curriculum. But are they truly rogue? To me, that implies that they were on their own. That may not fit the definition of “rogue” but my point is that in all cases, the focus is so finely tuned towards the individual and not the environment he was in (hey, who no female rogue traders?!)

Out there are people studying for their FRM or PRM designations (from GARP and PRMIA respectively) and I wonder what they’re thinking when they read today’s news. Same old story. Somehow, this guy knew how the back office worked. Somehow, despite all the debacles of the past, they’re still able to circumvent the safeguards that are in place. Just how “safe” these “guards” are … that might just be the key question. You simply have to wonder if this SocGen incident will make a difference in the way such institutions monitor and manage operational risks. Here’s an article from GARP that discusses this topic. Somehow, I feel like there will be minimal change in the way things operate at financial institutions.

My previous post discussed risk from the point of view of the financial advisor who services the individual investor. Here I want to think about risk from a more micro point of view. This “micro” view would apply to the internals of a bank, hedge fund or any big pile of money. Just as in my previous post, I think that the more things become complex (adding hedge funds to a portfolio, for example) the more things are susceptible to trouble. The derivatives markets are relatively complex and the mechanisms in the back office operations of seemingly sophisticated institutions allow for an individual with the right technical skill set to determine where is the weakest link and, if given the opportunity, take advantage of that knowledge should it be required. Clearly, to take away the ability for an individual to exploit an opportunity is the objective of this exercise.

This is not a call to tell financial advisors to stay away from hedge funds. My argument there has always been for financial advisors to realize that the resources required to adequately determine which (if any) hedge funds belong in client portfolios is quite onerous. Nor is this posting meant to be a purely negative assessment of the derivatives industry. In fact, my point in this blog is that derivatives are not bad themselves but, as everyone knows, are like dynamite … things can get out of hand quite quickly. I believe we can’t simply ask why the banks and hedge funds haven’t tightened up their operations so that such blowups can’t happen or are at least minimized in terms of magnitude via some set of protocols. Surely, the risk managers, the top officers and board of directors would want and have placed such risk policies and procedures in place. Shouldn’t they have? The question is simply implementation.

Perhaps it’s just not possible to make a fool-proof security system. I’m thinking of a cornered cat. It’ll come out fighting if required. Now think of Nick Leeson or this new guy Jerome Kerviel. You’ve been allowed to trade, things might be going well (you’ve had that feeling at the craps tables in Vegas, right?) and you’re on top of the world. Nothing different there. Nothing wrong. That’s just human nature. But nothing goes up forever and sometimes things go bad. Hey, crap happens but every so often things really get out of hand. Sometimes, we hold onto losses no matter how bad they get. Normally, one would eventually accept the situation and simply exit the position.

For some, that might simply mean taking a big loss. For some, that might mean shutting down their hedge fund and starting up a new one under a new name. But for some, there’s something else that’s entirely sinister. A common theme in the financial blowup is the hiding of losses. In some cases (I’m thinking of some hedge fund blowups but not Amaranth as far as I know) the trader tries to siphon some money away. I think the idea is “Damn, I’ve lost a ton of money. My career is over. If I’m going to go run and hide, I better take some cash with me.” I don’t think that was the case with Leeson and now Kerviel. There’s was simply trading gone bad and a futile attempt to hide the losses. In both situations, the inevitable story is one of a world slowly closing in around them with the noose tightening ever so slightly until the eventual day when they’re on the front page/screen of every media outlet on the planet. I suppose that’s the ultimate risk of any institution (note how I’ve just flipped this to not focus on the individual - they’re not thinking about this risk because no one ever plans to participate in a blowup). Congrats Socgen, you’ve just gained a new perspective on risk. Welcome to the world of “front page risk”. That’s a toughy to measure and is not like VaR and standard deviation covered in most textbooks.

The perception of risk is really not that difficult a subject. I think it’s amazing how a significant event like this can crystallize what risk management is all about. I think it’s less about risk management and more about thinking of all the steps in the process and what can go wrong at each step. Like many things in life, I suppose it all comes down to the details.

Last week I was in Palm Beach Gardens, Florida where I spoke at the “Inside ETFs” conference produced by Exchange-Traded Funds Report (ETFR) and Financial Advisor Magazine. Great location and perfect weather but unfortunately it was a quick 24 hours on the ground and virtually all business. But well worth the time. Unlike the vast majority of other ETF related events I have been to in the past year, this conference was not dominated by those employed by ETF provider firms but rather by financial advisors. And for a first time event, well … I’ve never seen that many attendees for an inaugural conference. Kudos to the organizers but it also says something about the growth of ETFs.

Anyway, on the afternoon of day one, I was a panelist on a discussion focused on investment risk. I ended up getting into a bit of an “anti hedge fund rant” which was not my intention and part of this blog entry is to clarify some points which could not be made simply due to the limited time allotted to our session.

So, what follows is what I would have hoped to cover that day, either did cover in a relatively light matter or not at all, or have considered now that a few days have passed.

First, because this event was targeted towards financial advisors, my perception is skewed to what I know of this type of intermediary. From our session and confirmed on many other session, it seemed clear that the financial advisor’s role within the portfolio building function focuses more on asset allocation than anything else. The comments from my fellow panelists (all financial advisors with strong acumen based on the discussions we had in preparation for the event) further confirmed this. Manager selection may be in integral part of the process but it seemed like rebalancing issues and related matters revolving around portfolio maintenance were of paramount importance. And this makes sense if they’re participating at an ETF focused event.

Now let’s focus on the subject of this post: risk. With a discussion on risk, an important point of differentiation is that between risk measurement and risk management. Over the years, I’ve seen many investment professionals increase their proficiency with risk measures such as standard deviation and correlation. Even more, some measures from college level math like higher moments and rather sophisticated downside measures like VaR are creeping into the more common industry dialogue. More than one of my fellow panelists mentioned the use of sensitivity analysis as well as Monte Carlo simulations. This is the power of the desktop computer and the internet. But it is also a point which must be clearly understood when we shift our thought from measurement to risk management.

Risk measurement attempts to provide some increased certainty in what is an uncertain endeavor. Certainty about what we saw in the past … that’s for sure. Certainty about what will come in the future? Well, statistical inference is a whole 2^nd year math course so I won’t go there in this post. There’s a reason why legal disclosures in investment related marketing materials include the phrase “Past performance is not indicative of future performance.” That’s because it’s true. The best I think we can say is that some investment methodologies may have greater certainty of behaving in some sort of way in the future. Note some uncertainty still exists. For example, with backtested results based on an index, we can say that, as opposed to backtests from an active manager, there is less concern of active management risk which can include the risk of style drift, among others

This leads to my next point of clarification. I think that the investment industry uses the idea of “more risk” or “less risk” too freely. What may actually be happening is not an increase or decrease in overall risk but simply a transfer of the type of risk.

One simple example is the “active-passive spectrum” which I have referred to in the past several times. For the sake of simplicity, let’s just keep this in the realm of stocks and the stock market. At one end of the spectrum is the pure passive world. Think beta. Think super low costs beta exposures like S&P 500 index futures contracts or the S&P 500 Spyder, SPY. This is where believers in market efficiency reside and they believe that exposure to market risk will pay off in the long term via the equity risk premium. The other end of the spectrum is the pure active world. Think alpha. Think much higher costs paid in an attempt to beat the market. This is best exemplified by hedge funds. Since there are multiple definitions of hedge funds, this end of the spectrum should really include only those that are market neutral, or perhaps more precise “beta neutral”. Essentially, at this end you should not be taking on any market risk as the manager has promised to outperform in both good and bad markets. If true (practically speaking, you will need that grain of salt if you accept this assumption), then you are not exposed to market risk but manager risk.

If you accept this paradigm of a see-saw of market risk versus manager risk, then for a financial advisor or any investor who decides to put some of their money within a particular asset class in ETFs versus an active manager, they are simply transferring risk. Anyone who says that by investing in an ETF over an active manager is taking the “lower risk approach” I believe is mistaken. As much as I like ETFs, I believe this choice is one of taking on market risk over manager risk. Again, not necessarily less risk.

Another investor who shifts between money in a bank account and a broad market ETF is also transferring risk. Actually, there are various risks which one is exposed to no matter which of these two paths one takes. The bank account clearly has the risk of not having enough funds for future spending as its growth is reduced due to unfavorable tax treatment and the future purchasing power is dependent on returns after inflation.

So let’s review. First, I’ve said that risk measurement is not the same as risk management. I didn’t say this before, but one of my concerns is that a process of risk measurement, no matter how thorough or robust, may lead to a false sense of security. That would, in fact, mean that risk measurement, if used inappropriately, could be counter-productive to the overall risk management function. This subject has been covered well in the best selling books of Nassim Taleb and I think both “Fooled By Randomness” and “The Black Swan” are required reading.

Second, I have differentiated between increased/decreased risk taking and risk transfer. Again, thinking this way may lead investors away from getting caught in the false sense of security that makes one think of various natural and man-made disasters. The Titanic is a good example. My first boss in the industry called it “banana peel risk”. These are more philosophical exercises which are not meant to cause higher blood pressure or an anal-retentive complex with the readers of this blog. This is just my opinion and I’m just trying to tell it like it is from my eyes.

Although I did not cover the above in great detail at the conference, what I did discuss was pretty close to this. However, what I did get a lot of feedback on after our session was my views on the fund space, both inside and outside ETFs.

One of my key points was that the evolution in the ETF industry was allowing investors to gain exposure to new asset classes and strategies. This would have the potential for investors to add further diversification to their portfolios and hopefully weather any sideways or downwards market, should that be the environment we now find ourselves in. Another point I stressed was that the new niche ETFs coming into the marketplace are certainly not meant for everyone. This also applies to many alternative investments including hedge funds which I’ll get to in a minute.

The simply beauty of ETFs is that they are the ultimate Swiss army knife. For everyone who has or ever used a similar multi-tool, we all have our favorite of its built in tools. I happen to use the corkscrew more than anything else. I think the blade is pretty useless. Actually, over the Swiss army knife I prefer my 12-year old Leatherman multi-tool which resembles this. Note that it has no corkscrew but is unique with its main set of pliers which is handy when fishing. What’s my point here? I have two multi-tools and I find certain things of value with each of them. You probably have one or both of these in your toolbox and likely others but only you know what works best for you in the common situations you find yourself in. I’m not big on brand loyalty and I just care about the quality/value proposition of a product and can only hope that it delivers as promised. Similarly, I don’t have any brand loyalty with ETFs … I’d be surprised if many investors do. The worst an ETF can do is not delivering as promised. Anyone who says that an ETF is “bad” because it’s not diversified enough, covers an esoteric asset class or is too narrow by sector is closed minded and frankly arrogant. Who are you to tell me or anyone else what to put in my portfolio unless you know my income needs, feelings on loss/volatility, time horizon or other parameters which determine my portfolio’s overall financial objective(s)? Now, if you’re my financial advisor and I’m paying for your advice, that’s a different story. Deep breath in … and now we continue.

Getting back to investing, after the 5 year bull run, investors likely need holdings to augment their core holdings. I’m not saying replace their SPY or EFA positions with a nanotechnology ETF or Chile fund. But there’s nothing to say that these types of holdings could provide improved risk-return characteristics in the future.

Now, some of the more controversial points I made last week were those around the use of hedge funds and even comments regarding hedge fund replication products. Well, as an extension to what I just said earlier, who am I or anyone to simply say “No” to the use of hedge funds? However, when an attendee asked me during the Q&A session my thoughts on the use of hedge funds, I started with a simple one word answer of “No”. Furthermore, when another listener asked my opinion on option-based strategies, my response was leaning more towards caution rather than a simple stamp of approval. Yikes. Looks like I’ve just painted myself in a corner. Time to explain myself.

Hopefully what I say now does not bring into disrepute the financial advisory profession. But I believe that the vast majority of financial advisors do not have the adequate resources necessary to adequately process hedge funds into their program. Frankly, the same could be said for many if not most investors. I won’t get into this into too much detail because I’ve said it so many times before on this blog but it takes a lot of specialized skills conduct the necessary qualitative and quantitative due diligence that goes into the vetting process of weeding out the many hedge funds that come knocking down one’s door. And there are a lot of them … again, too many participants trying to get that alpha … there’s just not enough to share. This leads to too many losers and not enough winners. Worse still, many of the “winners” are closed to new investors. And with hedge fund managers wanting to keep up with past performance in an ever changing and tougher world, leverage is often used in an attempt to juice returns. It all makes a lot of sense and you can’t knock them for doing what they do. The system allows them to get paid based on performance so if they’re able to try, they will.

However, if financial advisors are shifting from mutual funds to ETFs because of lower fees and the folly of “closet indexing” among many mutual funds, one has to wonder if the appeal for hedge funds is worthy. Many financial advisors find themselves accepting the fact that selecting hedge funds is as tough, if not tougher than with mutual funds. Hence,.the fund-of-funds is a common avenue. The unfortunate reality with FOFs is that their added layer of fees adds further necessary returns just to be breakeven and their tendency to perform closer to common benchmark equity indices is even greater than with single strategy hedge funds.

Buy quality? Goldman Sach’s Global Alpha hedge fund is a commonly cited example of where this line of thinking may not apply. In fact, many large institutional investors, backed by academic studies, have realized that emerging (read smaller) managers have the greatest potential due to their nimble operations to extract true alpha from global markets. Whether there is consistent alpha from these managers is questionable which leads to the idea of rotating managers more frequently than one may deem reasonable. But philosophically, it makes sense to me that small managers with knowledge “ahead of the pack” can outwit other participants who are relatively late to the game within a particular and likely newer/esoteric segment of the capital markets.

All of this led me to my answer of “No” to financial advisors getting into hedge funds. I was also not very accommodative to the new world of hedge fund replication products. One new entrant in the ETF industry has been cited in the press several times in regard to its product development in this area. Whether it’s a good product for the ETF marketplace, I can’t say right now and without full details, it’s hard to say yea or nay at this point. The only thing that can be said for now about HF replication is that it brings a new benchmark for hedge funds to go after. I mean, any financial advisor might be able to say in the near future “Um, Mr. Hedge Fund Manager, I can go to a replication ETF with much lower costs to get something that might likely perform very similarly to your fund’s strategy without many of the risks that keep me up at night.” This argument would be very similar to the idea of investors shifting from actively managed mutual funds to index funds or ETFs because of the closet indexing prevalent in many mutual funds. Clearly, the fact that so much beta is embedded in hedge funds in aggregate (a very important point to stress is “in aggregate”), is a telling sign and flaw of hedge funds that makes this new world of replication both insightful and alarming.

Of course, there’s no absolute “black and white” answer to the use of hedge funds or HF replicators and like other market participants, financial advisors must differentiate themselves from their peers. So, my “No” is in general but will find exceptions from those firms willing and able to allocate the necessary resources to a dedicated “hedge fund due diligence team”. Same goes for building an option overlay program.

Above is a chart showing the performance of some common equity benchmark indices with a broad hedge fund index. The main point I want to make here is that during the strong bull markets of 1993-2000 and 2003-2007, the hedge fund index was basically similar in scope and trend to an index fund. However, during the bear market of 2000-2003 it behaved like a high-yielding cash/bond position. In other words, the hedge fund index seemed to have a built in put option in play that paid off well during the bear market. The conference attendee who asked about options may have had a chart like this in mind. My response to the gentlemen and my comment here is that an option overlay program makes sense depending on the confidence you have in your own market timing abilities. For many, market timing abilities are about as reliable as one’s knack for coin flipping.

One insightful friend of mine thinks of option overlays in this way: If you’ve made a lot of return during an extended bull market (think 2000 or 2007), why not spend some of that return on an insurance policy. You’d do the same with your life insurance policy if your income increases dramatically. You’d to similarly again if you move into a bigger house. Why not protect another important asset that has grown dramatically? Makes a ton of sense to me. Just too bad that insurance is very expensive … pretty much true for any type of insurance including premiums in the options markets.

And there’s the rub. No matter if we’re talking about adding higher fee ETF diversifiers, even higher costing hedge funds or insurance policies like a put option, it won’t come cheap and the process won’t be easy. But that’s pretty much the definition of alpha ain’t it.

Mine is not the place to tell any financial advisor or investor what to do. It’s all about choice. If now is the time to think defensively for one’s portfolio, there are multiple levels of protection that can be applied:

• Diversify further into developing markets and alternative asset classes/strategies
• Diversify beyond market cap weighted indexing to dividend weighted or other forms of fundamental weighted or even equal weighted indexing
• Shift asset allocation to decrease enlarged positions and build cash
• Perhaps even make a tactical call to hold excess cash
• Apply the use of options in various ways to provide non-linear payoff characteristics
• Apply the use of inverse ETFs or outright shorting.

Financial advisors, like investors, come in different types with various degrees of proficiency and complexity. If the above are some of the various steps to increased complexity, one’s own personal philosophy on investing will likely determine where they fit. One thing’s for sure: The trend in the ETF industry towards niche exposures and specialized strategies such as inverse exposures lead most, including myself, to believe that the core positions like SPY and EFA have been done if not overdone. Investors are looking for the next step to finer tuned portfolios and this just makes sense. You can survive on meat and potatoes but multi-vitamins help just in case you’re missing something. This makes me think of the folic acid pills my wife took while she was pregnant. You just never know, and that’s the point of insurance.

To conclude, my comments at the conference were clearly tilted against hedge funds and more complex strategies for the majority of financial advisors. It’s just my opinion and of course that stance is entirely debatable. But I make my final argument here: Perhaps in the overlying concern of uncertainty (not simply risk), one must ask themselves if it’s even worth the exercise. I mean, for most financial advisors, I can see the benefits of ETF-based investing or at least, biasing their clients’ portfolios with the use of ETFs. I can even understand the benefits of using ETFs, among certain other instruments to gain exposures to developing markets, alternative asset classes and certain strategies. But adding hedge funds and somewhat complex derivative strategies … does it provide their clients greater certainty of success? Or perhaps a more succinct question: Does it provide clients a greater level of comfort to apply these strategies on top of the ETF based portfolio? Or does it not. For the financial advisor, there’s the real risk to consider in my opinion.