White Paper




Written by                         Hedge Funds within a Wealth Management Strategy
Robert J. Klosterman
Wh...
So is the news all negative? We say no for                             •      Absolute return strategy as                 ...
When using a chart such as this, it is clear          This makes for some interesting statistical                         ...
Tax Efficiency: The White Oaks Perspective




                                              Monte Carlo Simulation       ...
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Hedge Funds within a Wealth Management Strategy

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Hedge Funds within a Wealth Management Strategy

  1. 1. White Paper Written by Hedge Funds within a Wealth Management Strategy Robert J. Klosterman White Oaks Wealth Advisors Robert J. Klosterman, CFP is a shareholder and President As pointed out in a previous post (“Feeling • Dependence on the skills of the of White Oaks Wealth Advisors. Hedgey?”) there has been a lot of publicity manager and/or management team may He has also served as national about the notion of using hedge funds within President of the Institute of leave an investor exposed if there is a an investment management strategy and departure of key team members or Certified Financial Planners, and as Chairman of the Twin whether or not such vehicles are distraction caused by personal or family Cities International Association appropriate, There are many points that are matters away from the portfolio. for Financial Planning. raised as issues to be concerned about. This should not come as a surprise since any • Event risk due to abrupt markets shifts www.whiteoakswealth.com potential investment has risks. The challenge can work against particular funds’ ability is to understand them and be able to within their niche expertise. balance the risks with the benefits to a person’s portfolio and wealth management • Use of highly leveraged and/or strategy. Let’s start with identifying the areas speculative investments such as of risk. futures contracts, options and short trades, exposes the portfolio to higher • Lack of transparency or the lack of the gains and losses. ability to see and personally assess the underlying activities of the fund • Incentive fee arrangements can act as manager(s) is often cited as a risk. The an encouragement to managers to fund managers will likely respond that speculate and take higher risks to that they are attempting to exploit enhance their compensation. inefficiencies in the market and do not want their strategy known to others. • Valuation of some securities. Particularly if securities are not traded • Loss of capital is true in most on a public market, they are valued on investments, however, the strategies the funds mangers expertise sometimes often used that might include leverage leading to wide disparities in the actual (borrowing), sophisticated trading value. strategies, taking positions in thinly traded securities and many other risks expose the owners of alternative If we were to stop here one could easily investments to a higher level of risk. conclude that investing in a hedge fund should not be considered and stop reading • Limited or no liquidity common to this piece now. It should also be mentioned investments of this type are common, the hedge funds are not available to all and leaving the investor with limited options frankly they shouldn’t be. The current rules if they desire to liquidate their by the SEC call for investors to need a investment. There is no established minimum of a $1,000,000 net worth to be market for interest in these investments able to invest in a hedge fund. The SEC has on the secondary markets. proposed raising the level to an even higher number in an attempt to assure unsophisticated investors are not likely to participate. 1
  2. 2. So is the news all negative? We say no for • Absolute return strategy as Hedge funds and the alternative investment the following reasons: alluded to above, can mean space in general provide important tools to underperforming in up markets but consider in protecting and enhancing a • Hedge Fund/Alternative also producing positive returns in portfolio within a wealth management Investments provide additional down markets as well. strategy. Careful screening of funds, diversification to a portfolio. If an investigation of the funds results (including investor believes that diversifying • Accessing top management is audit reports), manager interviews to across different types of the converse to the compensation ascertain strategies and relevant risks, investments or assets classes problem mentioned in risks above. thorough review and understanding of the makes sense for safety reasons Sometimes the best and brightest offering documents, understanding the they will likely be interested in recognize that they are better leverage used within the portfolio, and having more tools at their disposal served by setting up their own background checks can be useful tools in to reduce the volatility of their fund than being employed by determining whether or not a particular fund portfolio. The use of hedge funds, another firm. Tiger Woods, for or manager can play an important part in an private equity, commodities, and example, makes more money investor’s portfolio. other alternatives provide playing golf than most anybody additional options to enhance playing professionally. Why? The illustration below shows the potential returns and reduce risk. Because he is good at what he impact of adding a portfolio of hedge funds does and can market it well to a wealth management strategy. Using • Low correlation to market risk is besides. Increased flexibility in historical HFRI index returns, correlations how using these types of vehicles management and an and standard deviations of a mix of hedge can reduce the volatility of an entrepreneurial instinct lead many fund index strategies that include investment portfolio with a wealth managers to these types of convertible arbitrage, energy, Fixed Income management strategy. Hedge fund investment structures. Arbitrage, Event Driven, Equity Hedged and managers often focus more on Distressed Securities is compared to absolute return strategies than There are several examples of very smart comparable returns, correlations and “market returns”. This means their people where their strategies “blew up”. standard deviations of a traditional mix of portfolios will likely behave in a Long Term Capital Management (run by assets that include stocks and bonds. The different manner than one that is Nobel Laureates), SOWA Capital and further one goes to the right on the chart more exposed to beta or market others where some of the risks above the higher the volatility of fluctuation of the only risk. This is particularly became very apparent. That is why portfolio. The higher you go on the chart, important in portfolios that are significant due diligence and limited the higher the expected return based on intended for financial exposure to one manager or particular historical averages. The sloping lines independence purposes and strategy is important. Large endowment represent efficient portfolios. The dashed regular withdrawals to sustain funds have been increasing their use of line represents the traditional asset classes lifestyle are planned. these vehicles for the reasons above. and the steeply sloped line to the right Harvard and Yale have 15% and 25%, represents the potential efficient portfolios respectively, of their portfolios allocated for the hedge fund portfolios. towards alternative investments. Basic Allocation Analy sis Zephy r Alloc ationADVISOR: White Oak s Wealth Adv is ors , Inc . Efficient Frontier Case: Alt Funds Constrained Return vs. Risk (Standard Deviation) 17 Alt Funds Constrained 16 Traditional 15 Mix 3 14 13 12 Mix 2 Return 11 10 Mix 1 9 8 7 6 0 5 10 15 20 25 30 Risk (Standard Deviation) 2
  3. 3. When using a chart such as this, it is clear This makes for some interesting statistical I don’t know any financial advisor who that the risk return characteristics are information but how does this factor into a would recommend 100% of a portfolio to potentially very attractive for investing in a real scenario? Let’s assume that an alternative investments and we would not portfolio of this type. It is important to note investor has a portfolio of $5,000,000 and consider it prudent either. But to consider that past history is no assurance of a future needs to withdraw $200,000 per year 20-30 per cent in a long term wealth result and the portfolio has constraints to adjusted for inflation at 3%. The first graph management strategy may in fact be very put no more than 25% into any one that follows represents the Hedge Fund appropriate and useful in meeting long- strategy. portfolio. Using Monte Carlo modeling that term financial objectives. runs 10,000 simulations the portfolio value th Hedge funds and Alternative investment before taxes in the 50 percentile would be strategies are not for everyone, but to not over $15,000,000. In the 90th percentile If you would like to learn more about the examine the risks and rewards of whether (leaving a 10% probability of a lower financial services provided by White Oaks or not these tools will bring value to your number) the value is over $11,000,000. Wealth Advisors, Inc., call us at wealth management strategy would be like The second graph is targeting the same 800-596-3579, or visit Tiger Woods deciding to not take all his risk or volatility of the portfolio but using www.whiteoakswealth.com. clubs to the next tournament. He may traditional stock and bond asset classes. decide not to take all on a particular round Here in the 50th percentile the portfolio Click here to request additional information. for many well thought out reasons but to value is a little over $9,000,000 compared not have all the tools at his disposal would to over $15,000,000 for the hedge fund Click here for links to other white papers by th seem to be unprepared. As pointed out portfolio or 65% difference. In the 90 Robert J. Klosterman. above there are many risks with these Percentile the numbers are also dramatic types of investments. There is no with nearly an 80% difference. Of course, © 2008 White Oaks Wealth Advisors, Inc. Al substitute for a complete due diligence on past results do not guarantee future or will rights reserved. any hedge fund strategy within a wealth be indicative of future performance, but management strategy. clearly to not consider these assets classes leaves important tools on the table. Monte Carlo Simulation Zephyr AllocationADVISOR: White Oaks Wealth Advisors, Inc. Portfolio Value Case: Hedge Funds Initial Value: $5,000,000 Inflation Rate: 3.00% 30M 25M 20M Value 15M 10M 5M 0 0 5 10 Year Portfolio Value Case: Hedge Funds Initial Value: $5,000,000 Wealth Goal: $1,000,000 Inflation Rate: 3.00% Simulation Trials Year 5 Year 10 Portfolio Value 10th Percentile: $10,290,275 $20,200,736 25th Percentile: $9,424,876 $17,720,742 50th Percentile: $8,497,279 $15,218,417 75th Percentile: $7,681,045 $13,108,790 90th Percentile: $7,012,562 $11,462,758 Flows $200k Per Year Average Flow: ($231,855) ($268,783) 3
  4. 4. Tax Efficiency: The White Oaks Perspective Monte Carlo Simulation Zephyr AllocationADVISOR: White Oaks Wealth Advisors, Inc. Portfolio Value Case: Traditional Initial Value: $5,000,000 Inflation Rate: 3.00% 25M 20M 15M Value 10M 5M 0 0 5 10 Year Portfolio Value Case: Traditional Initial Value: $5,000,000 Wealth Goal: $1,000,000 Inflation Rate: 3.00% Simulation Trials Year 5 Year 10 Portfolio Value 10th Percentile: $8,463,761 $13,085,750 25th Percentile: $7,536,916 $11,045,266 50th Percentile: $6,688,782 $9,190,796 75th Percentile: $5,922,718 $7,603,012 90th Percentile: $5,282,805 $6,380,215 Flows $200k per year Average Flow: ($231,855) ($268,783) 4

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