At Convergent Wealth Advisors, the alternative strategy of choice nearly always includes hedge funds.
Across the industry, advisers are looking for less correlation with equities. Investing in foreign stocks used to offer that diversity, but today, they mostly track U.S. company shares, said John Workman, chief investment strategist at Convergent Wealth.
“We think of hedge funds as being the most significant portion of the alternatives category,” Mr. Workman said.
The advisory firm places between 25% and 50% of client assets into alternatives aimed at protecting against the downside risk of equities. A portfolio may incorporate directional hedges such as long/short equity strategies and those with a nondirectional or multistrategy focus incorporating distressed-debt or market-neutral investments.
HOLISTIC APPROACH
“We look at portfolios holistically and try to construct them to return the most with the least amount of risk,” Mr. Workman said. “With hedge funds, we've found historically that we can get some true diversification there.”
For large clients, the firm invests directly with hedge funds to achieve diversification, while smaller clients are handled through a fund of funds. Convergent uses a broad roster of investment management companies for its alternatives mix, Mr. Workman said.
The firm looks for hedge fund strategies that try to achieve a particular return that is less dependent on the market, “less beta-driven and more alpha-driven,” he said.
In particular, the advisory firm seeks hedge fund managers who have a “broad tool belt to achieve or generate that alpha,” Mr. Workman said. For example, he said he appreciates managers who can choose individual securities, be long or short on equities and can cross asset classes.
A manager who can evaluate a company and pick out the most attractive part of its capital structure — whether that's equity, debt or a type of hybrid security — will create a better potential for alpha, Mr. Workman said. In addition, the strategy must make sense and be repeatable.
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He also wants a manager's financial incentives to be aligned with those of Convergent's clients. The firm looks for professionals who have most of their personal net worth invested in their strategy.
“Today it's more critical that they have a meaningful investment, and we focus on it,” he said.
Convergent also checks that the hedge fund's back-office and operating teams are strong and using best practices.
Events such as those that led to the collapse of MF Global Holdings Ltd. and Bernard Madoff's fraud are flagrant reminders of the importance of due diligence, Mr. Workman said. These headlines have caused those in the industry to re-evaluate their own processes to make sure they are sound, especially when it comes to compliance, risk management and security of assets.
“You have to keep your eye out and hope that you avoid these problems,” Mr. Workman said. “We didn't have exposure to MF Global, but we certainly looked at whether we can learn from it.”
His due diligence includes analyzing whether the liquidity of the fund matches up with the underlying investments. Having assets tied into investments that cannot be sold daily or monthly allows the hedge funds Convergent uses to invest in things that a mutual fund could not.
The firm is willing to take on investments that are liquid only quarterly or even annually as long as they pay a premium, Mr. Workman said. Similarly, Convergent invests in nonagency mortgages, which can be less liquid than traditional mortgages.
“There's a premium paid back for that risk,” Mr. Workman said.
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