Subprime chaos, credit crunch recast alternatives

One way or another, the fallout from the subprime mortgage meltdown and the broader credit crunch is expected to alter the complexion of the alternative investments industry in the year ahead. "We will see some hedge fund liquidations as a direct result of the subprime situation," said John Van, chief operating officer of Partners Capital Group LLC in Nashville, Tenn. The hedge fund industry, estimated to have at least $2 trillion invested through more than 12,000 funds, is particularly vulnerable on the fixed-income side, according to Mr. Van. "We've already seen some carnage there," he said. The reductions of available credit will mean a greater emphasis on management skill, as opposed to the willingness to take leveraged bets, according to George Feiger, chairman and chief executive of Contango Capital Advisors Inc., a Berkeley, Calif.-based firm that oversees $1.9 billion in assets. "Until now, much of the growth in the hedge funds industry has come from the use of leverage, but we're now looking at a systematic reduction in the willingness of prime brokers to provide leverage," he said. "This will lead to a huge rebalancing of the whole industry away from reliance on leverage and toward management skill, and from there we'll see a sorting out and massive compression on the leverage side of the business."

PRESSURE FELT

As tighter credit markets place more emphasis on actual hedging strategies and manager skill, the pressure is likely to be felt by many of the marginally successful hedge funds, said Ryan Tagal, director of alternative investments at Morningstar Inc. in Chicago. "There are so many hedge funds out there now that it's only going to get harder for the managers to generate alpha, which is going to drive some hedge funds deeper into more exotic markets and strategies," he said. "The big question is still how the limits on liquidity are going to impact hedge fund strategies." The uncertainty of the broader implications of the credit crunch has become a major focus for Greg Althans, chief investment officer at Fairpoint Asset Management LLC in Cleveland. The firm, which oversees $1.1 billion in assets, caters to wealthy individuals and often allocates assets to hedge funds, private equity and various types of structured products. "Everybody seems to be running to hedge funds, but with the subprime mess, there are questions surrounding the idea of looming hedge fund blowups," said Mr. Althans, who diversifies risk on the hedge fund side by investing in funds of hedge funds. However, he is committed to the idea that alternatives are the best way to achieve returns that don't move in lockstep with the broad equity markets. "Assuming you have good managers, the higher market volatility is attractive," Mr. Althans said. "And I think we'll continue to see pretty significant volatility from the major stock indexes." He has also started adding different types of structured products to client portfolios, with a particular emphasis on gaining exposure to a wide range of indexes. Structured products generally involve the use of derivatives to provide investors with a specific balance of capital protection, income generation and capital appreciation. They have fixed maturities, and the condition of each product also is fixed in advance. "I don't believe the credit crunch will have as big an impact on structured products as it will on hedge funds because it's a very competitive market and different offerings are coming out every week," Mr. Althans said. "But we are paying close attention to who is issuing what and making sure they can back it up."

FEELING THE PINCH

Structured products, which rely on credit in different ways than do hedge funds, are still expected to feel the credit pinch, according to Keith Styrcula, president of the Structured Products Association in New York. Industrywide, structured product sales will surpass $95 billion this year, up from $64 billion in 2006. The growth in the year ahead is likely to reflect bearish plays on housing and the credit markets, Mr. Styrcula said. Just as financial advisers are starting to take notice, however, they might find some new constraints on the structured products as a result of the tighter credit markets, he said. "Structured products require internal [bank] credit at issuance, and that credit has become more limited," Mr. Styrcula said. "This could raise the price of that credit inside the bank, or it could lead to some longer terms from principal protection products." In order to introduce greater numbers of independent financial advisers to structured products, the industry has started "bleeding the commissions out," Mr. Styrcula said. "The major issuers have started focusing on fee-only advisers," he added. "We will continue to see more special commission-free offerings." Jeff Benjamin can be reached at jbenjamin@crain.com.