What is an Accredited Investor ? (Morningstar)

New Law Changes Wealth Definition


by Tim Galbraith | 07-23-10


President Obama just signed into law a sweeping set of financial reforms contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act. One significant change is the modification of the definition of an "accredited investor."

Accredited investors are a minority in the United States, as the description imposes high-net-worth thresholds. There are many details in the definition, but broadly speaking, the historical accredited investor standard meant investors had to earn $200,000 during the previous two years with the likelihood of earning the same during the forthcoming year. Alternatively, investors not meeting this income test could qualify for accredited investor status by having at least $1 million of net worth, which included all investments and, critically, one's home.

Accredited Growth
These income and asset rules were put into place in 1982. In that year, the SEC estimated that only 1.87% of U.S. households would pass either of those financial tests. With the march of time, inflation and asset appreciation increased incomes, home prices, and the value of other investments. Take for example incomes: Government statistics show that in 1982 the top 5% of households earned just more than $60,000 and by 2008 the income level was $180,000--an increase of 200%. Average home prices rose 237% in the same period, and in some metropolitan areas the appreciation was much more.

The SEC estimated that the percentage of accredited investors increased by 350% from 1982 to approximately 8.47% of households in 2003. In 2010 the percentage was likely higher despite the recent housing and 2008 equity market correction. Like many things that do not adjust for inflation, the old definitions got easier to meet and more investors, even though they may not have felt rich, were now members of the top investment club.

An individual who meets the definition of an accredited investor has access to a group of investment products unavailable to the retail masses, namely private partnerships that can invest in private equity, real estate, commodities, and hedge fund strategies. It is common sense that legislation put in place net-worth tests to limit access to these types of strategies, which typically have poor transparency, intermittent pricing, and episodic liquidity. However, more sophisticated investors who understand the greater risks could potentially benefit from greater return from these investments.

But as net worth increased over time, many investors found themselves technically eligible to be accredited investors, though their own investment proficiency was less than a perfect match for these complicated products. It is easy to imagine a pensioner or school teacher, not able to meet the $200,000 income threshold, but who owns a home in an affluent area, where the housing bubble lifted their net worth more than $1 million. Are they really an accredited investor, able to judge complex trading strategies, partnership tax treatment, or esoteric securities such as a collateralized debt obligation?

Wealth Redefined
The new legislation immediately removes the value of a home when calculating the $1 million net worth limit. Newly minted accredited investors must have true investments in excess of $1 million. The $200,000 income threshold remains unchanged. Additionally, after four years the SEC has the ability to increase the $1 million bar to account for inflation, eliminating the problem of having a fixed net worth hurdle that gets easier to jump with the passage of time. Existing investors who no longer meet the newer accredited standards may not be forced to redeem, but no new money will be permitted to be added unless the investor qualifies.

The most immediate impact of this legislation will be felt on those operating investment products that are limited to accredited investors, namely private partnerships, including hedge funds. The tighter standards will shrink the number of prospects, forcing these partnerships to target larger qualified and institutional clients. Additionally, there will be more scrutiny on partnerships to ensure their accredited investors really meet the new standards. Ultimately, an investment partnership is responsible for ensuring compliance with all securities laws, particularly Regulation D of Rule 501 in the Securities Act of 1933, commonly known as "Reg D." This is where the definition of accredited investor is detailed and the rules of private fund investor solicitation are laid out.

"No one conducts financial audits or demands absolute proof of net worth," says Rory Cohen, partner at the law firm Venable LLP. "But clients typically attest to their net worth through subscription documents, on which broker-dealers and funds rely. Ultimately, the investment partnership is responsible for its ability to assert compliance with the Reg D safe harbor. Partnerships ought to show some reasonable level of diligence in confirming that an investor meets the eligibility requirements."

For funds that target accredited investors, the responsibility to meet the new standards falls to the fund and its general partner. Adds Cohen, "Funds should have a pre-existing substantive relationship with each investor, through which they could gain sufficient information about an investor's occupation and financial circumstances to better assess whether they are accredited. When in doubt, it would be prudent to ask for a tax return."

What are the penalties for failing to meet the Reg D requirements? "Failure to adhere to the private placement requirements could lead to fines and potentially far more punitive measures," says Cohen. The ultimate sanction would be closing a fund and liquidation. The high fees charged to investors by hedge funds means many funds are wealth-creation machines for their fund managers. For a fund manager charging a 2% management fee and a 20% performance fee, closing a partnership is the equivalent of taking the Golden Goose to a barbeque.

For retail investors, it can be argued that the new higher standards to become an accredited investor provide additional protection. Investors can be better matched to investment products that suit their level of understanding and sophistication. For clients and financial advisors, once again, suitability reigns supreme.

One other possible outcome from the new definition could be an increase in the number of mutual funds and exchange-traded funds that attempt to mimic the same strategies as these private partnerships. If you run a private partnership, the new definition means there are fewer prospects; asset raising is more difficult and more costly.

One option is to scrap your partnership and open a mutual fund, where there is no net-worth threshold for investors. The numbers of these alternative mutual funds are growing, and include such hedge fund styles as long-short and market-neutral. Morningstar's last count was 153 funds, with more in the pipeline. For retail investors, the benefits include daily liquidity and pricing, a 1099 tax form instead of a K-1, and no minimum net-worth requirements.

We are encouraged by these changes as they provide additional investor protections. Time will tell if this legislation will be the catalyst for new financial product innovation, nudging private money managers to open mass-appeal products. We are hopeful and very watchful as innovation brings new but not always enduring products. The lasting lesson is something we've known all along, that client suitability is timeless, and knowing your client (and their limits) is a protection that legislation can never universally provide.

Data Sources:
Census.gov (housing data) http://www.census.gov/const/uspricemon.pdf
Census.gov (top 5% income) CPS data
U.S. Congress conference report for HR4173
Federal Register / Vol. 72, No. 2 / Thursday, January 4, 2007 / Proposed Rules (SEC) stats on numbers of accredited investors

Tim Galbraith is head of alternative investment strategies for Morningstar Associates, LLC.

Where the Professionals are Investing (WSJ)

Where the Financial Gurus Are Putting Their Own Money

By Eleanor Laise, The Wall Street Journal

Last update: 3:27 p.m. EST Jan. 29, 2009

In times of market strife, financial gurus often tell investors to think long-term and stay the course. Some of them even put their own money where their mouth is.

A sampling of high-profile industry veterans, academics and brokerage-firm chiefs reveals that many are hanging on to holdings battered by last year's market slide and busily hunting down new opportunities, particularly among bonds and beaten-down value stocks. Some are snapping up municipal bonds, inflation-indexed securities and steady-Eddie dividend-paying stocks.
And they're generally upbeat about the prospects for long-term retirement savers.
"I think this is a marvelous time to be investing," says Rob Arnott, the 54-year-old chairman of Research Affiliates LLC, an investment-management firm in Newport Beach, Calif. "There are more interesting opportunities out there now than any of today's investors have ever seen." Financial stars are facing some of the same retirement-planning headaches as ordinary investors. Many suffered substantial losses last year in a market that crushed nearly everything. But unlike many small investors, they're patiently waiting and watching for bargains rather than making a mad dash for havens like cash or Treasury bonds or drastically revising their asset-allocation plans. And where possible, they're even stepping up their savings to put more cash to work in the market.
Certain parts of the bond market are priced for a scenario that's worse than the Great Depression.
Great investing minds don't always think alike, of course. John Bogle, the 79-year-old founder of mutual-fund giant Vanguard Group, says he has only about 25% of his portfolio in stocks, for example, while David Dreman, the 72-year-old chairman and chief investment officer of Dreman Value Management LLC, says he has a roughly 70% stock allocation. They do appear to have one thing in common, though: patience -- a trait many small investors lack. Last year, 401(k) participants shifted around 5.7% of their balances, compared with just over 3% in a typical year, according to consulting firm Hewitt Associates. Money flowed out of stock funds and into bond investments, money-market funds and stable-value products. And many fed-up and tapped-out investors have stopped contributing to retirement accounts altogether.

But this is hardly the time to hunker down and take bets off the table, financial pros say. Don Phillips, managing director at investment research firm Morningstar Inc., says he invests his entire individual retirement account in the Clipper Fund, a large-cap stock fund that lost about 50% last year. Early this year, he made the maximum IRA contribution to that fund, just as he has for the last 20 years. "It's long-term money, and you have to look at it that way," he says.
Here's how some top investing experts are now allocating their own retirement savings and handling the heavy blows being dealt by a volatile market.
Bonds
While many financial gurus say they're starting to spot some great opportunities in stocks, they believe the bargains in select corners of the bond market are even better. "Certain parts of the bond market are priced for a scenario that's worse than the Great Depression," Mr. Arnott says.
I earn my money and spend my money in dollars, and I don't need to take currency risk.

One favored area is Treasury Inflation-Protected Securities, or TIPS, a type of Treasury bond whose principal is adjusted based on changes in the inflation rate. Ten-year Treasurys currently yield only about 0.9 percentage point more than 10-year TIPS, indicating that investors believe inflation will remain quite low in the coming years. Mr. Arnott says he boosted his TIPS allocation "in a very big way" in his personal taxable account toward the end of last year because he expects a substantial increase in inflation in the next three to five years.
Municipal bonds also look attractive to many longtime investors. Munis are typically exempt from federal and, in many cases, state and local income taxes. Many are now yielding substantially more than comparable Treasury bonds. In his taxable account, Mr. Bogle holds two muni-bond funds: Vanguard Limited-Term Tax-Exempt and Vanguard Intermediate-Term Tax-Exempt.

Burton Malkiel, a 76-year-old economics professor at Princeton University and author of "A Random Walk Down Wall Street," says he boosted his allocation to highly rated tax-exempt bonds in his taxable account late last year, since yields available on some of these bonds were "unheard of." Some market watchers believe that it's time to take on more risk in their bond portfolios. Even investment-grade corporate bonds offer high yields, and below-investment-grade junk bonds yield far more than that. Mr. Arnott boosted his allocation to investment-grade corporate bonds in his personal taxable account late last year because the market had reached "irrationally high yields," he says. And Jeremy Siegel, a professor of finance at the University of Pennsylvania's Wharton School and senior adviser to exchange-traded-fund management firm WisdomTree Investments, has recently raised his allocation for junk bonds.
"Stocks and high-yield bonds will move together as the crisis passes," rebounding from their depressed levels, the 63-year-old Mr. Siegel says.
Stocks
Financial gurus are picking through the wreckage of last year's stock-market meltdown to find the best bargains.
Emerging-markets stocks have 'gotten cheap enough to really give value now.'
Jeremy Siegel, the Wharton SchoolSome are looking for companies with strong market positions and juicy dividends. Muriel Siebert, founder and chairwoman of brokerage firm Muriel Siebert & Co., has recently been buying shares of companies like Pfizer (
PFE) Inc., Altria Group (MO) Inc., and General Electric (GE) Co. "I don't mind buying a stock on the bottom and waiting," says the 76-year-old Ms. Siebert. "But I do think when you get a market like this, you should be paid while you wait." Pfizer and Altria yield roughly 8%, while GE yields over 9%.
Some battered stocks in the energy sector also look like bargains, Mr. Dreman says. He likes oil and gas exploration and production companies like Anadarko Petroleum (APC) Corp., Apache (APA) Corp., and Devon Energy (DVN) Corp. If we don't have a long world-wide recession -- a scenario that Mr. Dreman thinks oil prices currently reflect -- "we'll see much higher prices for oil again," he says.
More From the Gurus
•
Though foreign stocks were generally hit harder than U.S. shares last year, some gurus aren't rushing to invest overseas. Mr. Bogle, who says he has a very small allocation for international stocks, notes that investors poured money into foreign funds in recent years, chasing their strong returns, while yanking money out of lagging U.S. stock funds. "To me that's a red warning flag on a very tall flagpole on a very windy day," he says. "I also earn my money and spend my money in dollars, and I don't need to take currency risk."

Other experts say that emerging-markets stocks, which were hit especially hard last year, are starting to look tempting. If these shares take another dip, they could become "extremely interesting," Mr. Arnott says. Mr. Siegel keeps one-quarter to one-third of his foreign-stock allocation in emerging markets, and "they've gotten cheap enough to really give value now," he says. He has bought some more of these shares as they've declined in recent months.
Jim Rogers, a 66-year-old veteran commodities investor based in Singapore, is putting new money into Chinese shares. He's focusing on sectors of the economy that the Chinese are pushing to develop, such as agriculture, water, infrastructure and tourism.
Market gurus are also finding some bargains among alternative investments. Mr. Rogers is putting some new money into commodities, particularly agricultural commodities. "We're burning a lot of our food in fuel tanks right now," he says. And Mr. Siegel recently added some U.S. real estate investment trusts to his portfolio, which got "very cheap" after declining sharply last year, he says.
Staying the Course
Sticking to principles they've developed over decades in the market allows people who live and breathe investments to be relatively relaxed about their retirement portfolios.
I don't mind buying a stock on the bottom and waiting. But I do think when you get a market like this, you should be paid while you wait.
Muriel Siebert, Muriel Siebert & Co.Morningstar's Mr. Phillips, 46, has made it easier to stay the course. He has relinquished responsibility for allocating his 401(k) account, leaving those decisions in the hands of a managed-account program run by a unit of Morningstar. The program, which he started using in 2007, has "actually been very good for me," Mr. Phillips says. "They started putting me into things like TIPS and high-quality bond funds that I'd never had in the portfolio before."
And when they do suffer substantial losses, they tend not to panic. Mr. Phillips remains committed to his battered Clipper Fund, though it lagged the Standard & Poor's 500-stock index by about 13 percentage points last year. Ms. Siebert says she took a "very substantial loss" in Wachovia Corp. stock, which plummeted last year before the company was sold to Wells Fargo (WFC) & Co., but she's hanging on to the Wells Fargo stock she received "until I see a reason not to."
She is, however, a bit sensitive when asked about her portfolio's overall performance last year. "Do you want to see a grown woman cry?" she asks.


Write to Eleanor Laise at eleanor.laise@wsj.com

Safety First (from Barrons)

Monday, September 15, 2008




Retirement: Safety First
By KAREN HUBE

Risk experts explain how to keep your nest egg from cracking in shaky markets. Also, which investments offer the most stable returns during slumps? And, exotic real estate -- with an American twist.

THESE ARE SCARY TIMES FOR INVESTORS TRYING to protect and increase their retirement portfolios. With stock prices gyrating and major financial institutions crumbling, the mattress may look like as good a place as any to stash your holdings.

Not so fast. Take it from five titans of risk management: There are steps you can take to protect your nest egg for as longs the tumult lasts -- steps that will make sharp market dips much easier to endure.

Even better, without sacrificing those safeguards, you can position your retirement funds to participate in the earliest gains as the stock market begins to recover. And yes, these experts say, the market will recover.

So heed the practical advice and recommendations of the intellects whose views you'll read on the following pages -- Barton Briggs, Peter Bernstein, Charles Ellis, David Darst and Jeremy Siegel -- and reserve that mattress for some peaceful sleep.


Brad Trent
Peter Bernstein
Founder, Peter L. Bernstein Inc.

After almost six decades of contemplating market risk, Peter Bernstein knows how to spot investors' worst-case scenarios before they do. These days, what he sees concerns him deeply.





As the current economic crisis unfolds in ways that even the most bearish Wall Street strategists never predicted, Bernstein says any number of disasters could still be in store for investors. For those saving for retirement, in particular, taking protective measures is critical.

"The goal for investors right now should be survival, not making a killing," says Bernstein, who has been an economics professor and money manager, and is the author of several books, including Against the Gods, a classic on risk. "You should be thinking about how to hedge against extreme outcomes."

With markets down and unemployment and home foreclosures rising, what more could happen?

"A major bank failure, causing a run on banks in general," Bernstein speculates. Or "a run on the dollar, perhaps provoked by what foreigners view as too big a fiscal deficit."

Or runaway inflation or deflation, either of which could be disastrous for long-term retirement investors.

The next step of this crisis is hard to predict, Bernstein says, because the crisis is so unusual. "Nothing like this has ever happened before," he continues. "There have been credit crunches and housing crises and dollar crises, but having all the chickens coming home to roost at the same time and interacting with one another is unique. We have historical perspective on the parts, but not the whole, and that makes things both interesting and scary."

He suggests diversifying a portfolio so that it is not only exposed to many different markets, but also to ensure it can weather all kinds of scenarios.

For example, to guard against rampant inflation, every portfolio should contain at least a sprinkling of Treasury inflation-protected securities and short-term Treasuries, Bernstein suggests.

The TIPS come with a guaranteed return above inflation, and short-term Treasuries enable you to roll your money into higher-yielding issues every 90 days if inflation rises and interest rates follow.

"Short-term Treasuries aren't a very good holding under normal conditions, but they are a hedge against extreme conditions," Bernstein says. Long-term Treasuries are a good hedge against deflation, he adds.

Bernstein also recommends holding some gold as a hedge against a collapse in the value of the dollar if China or other nations decide they no longer want to invest as much in U.S. Treasuries. "In a total disaster, where there is a run from paper currency, you'll get your biggest bang for your buck in gold," he says.

You don't have to buy much gold to have an effective hedge, he adds, noting that "if everything hits the fan, gold could be worth several thousand dollars an ounce." It is now valued at about $750 an ounce.

Above all, don't let your defensive attitude waver, Bernstein counsels.

"Every day, we are faced by the possibility that something we never dreamed of will happen," he cautions.

"In 1958, I'd been in the business for seven years when, for the first time in history, bonds yielded more than stocks. My associates said, 'It's an anomaly, don't worry, it will be reversed.' It's 50 years later, and I'm still waiting."


Gary Spector
Charles Ellis
Founder, Greenwich Associates

In Japan, investors fill their stock portfolios primarily with Japanese companies. The French place their biggest bets on French companies. The story is the same in New Zealand, India, Russia, and around the globe: Investors favor their own countries' stocks.

For U.S. investors it's easy to criticize foreign investors for being provincial. But Charles Ellis, a former chair of Yale's Investment Committee and a consultant for institutional investors, has a suggestion for them: Look in the mirror.

The typical U.S. investor holds at least 85% of his stock portfolio in domestic stocks, even though the U.S. stock market accounts for only 40% to 45% of the world's total stock-market value.

"People feel more comfortable emphasizing their own country, because they recognize the company names," says Ellis, whose internationally renowned book is Winning the Loser's Game. "But from a pure investment point of view, it doesn't do any good" -- particularly for folks investing for retirement and other long-term goals, he says.

A U.S.-centric stock portfolio creates high levels of volatility, and denies investors the benefit of surging markets around the world, Ellis notes.

The best risk-adjusted returns over the long term can be scored by matching the market capitalization weightings of the world's markets, Ellis says. That would mean putting 45% in domestic stocks, 47% in developed foreign markets and 8% in developing foreign markets.

The idea is to have no bets on whether one market or another will be stronger in coming months.

"If you said, 'I don't really have a smart idea about the direction of the markets, I'm just a sensible person, what should I do?,' the answer is to go to a global index and start there," Ellis says. "If you have reason to make any changes from there...then you can adjust it from a neutral to an opinionated portfolio."

Traditionally, investors have been hesitant to plunge more deeply into foreign markets -- because of perceptions that foreign-currency exposure presents too much risk, foreign companies don't get enough oversight from their governments, and foreign markets are simply too volatile.

To Ellis, however, the truly global allocation of assets trumps all those concerns.

"There really is a free lunch, and it's called diversification," he says. "By diversifying, you reduce your risk substantially. It doesn't cost anything, and you get something for it."


Evan Kafka
Barton Biggs
Managing Partner, Traxis Partners

When the herd zigs, Barton Biggs zags. So it shouldn't be a surprise that while U.S. investors can't dump their technology stocks fast enough these days, Biggs has been declaring that now is the time to get into the trampled tech sector.

The best values right now, he says, are in large-cap, high-quality stocks around the world, "but particularly in the U.S., and within that category, technology appeals to me the most."

Biggs, co-founder and managing partner of the $1.3 billion hedge fund Traxis Partners in New York, is the former global investment strategist at Morgan Stanley.

"We've been in a period of stagnation in terms of tech spending since the bubble burst in 2000. The next recovery is going to be marked by unusual spending in all types of technology...and the sector will be one of the first areas to pick up as the U.S. and the world begin to recover," Biggs says.

A market recovery, he believes, will begin in the first half of 2009. By then, oil prices should be consistently below $120 a barrel, and the housing market should have started stabilizing.

Due to the government's takeover of Fannie Mae (ticker: FNM) and Freddie Mac (FRE) -- which he characterizes as "one of the most important events of the last 20 years" -- further declines in home prices are likely to be more moderate than expected earlier.

But don't wait for an economic recovery in order to step into large domestic stocks and global tech stocks, or "the markets will already be up," Biggs says. "I wouldn't be surprised if later, in retrospect, we will find that the stock market is at its bottom about now."

Biggs is a notoriously trend-bucking strategist, which has sometimes paid off massively for those who follow him. In the late 1990s, he spared his clients huge losses by predicting the technology-driven bull market was going to plummet. And in 2003, when investors were steering clear of Japan, he moved into the Japanese stock market, adding untold wealth to clients' portfolios in the following three years as Japan soared.

Today, while many Wall Street strategists are recommending an underweighted position in stocks, Biggs is defiantly upbeat." The public has been selling stocks and has an incredible amount of liquidity, and so have institutions and hedge funds," he says.

"The fact that everyone is cautious has raised a lot of investable funds, and that's bullish," he adds. "We're in a stage where ordinary investors ought to be buying on weakness," says Biggs.

Some of his top picks: Cisco (CSCO), IBM (IBM) and Google (GOOG).

Biggs is steering clear, for now, of stocks in the materials, energy, agricultural and industrial- and oil-commodity sectors, but notes that "those will come on strong again -- but not until further into the recovery."


Dave Moser
Jeremy Siegel,
Professor, Wharton School

To most investors, dividend-paying stocks seem about as cutting edge as a corded telephone. Yet Jeremy Siegel talks about stock dividends with the enthusiasm and sense of discovery of a first-time iPhone user.

Through his recent research, Siegel, a finance professor at the University of Pennsylvania's Wharton School of Business, has become enamored of the dividend, and hopes to elevate its status from a humdrum staple for retirement-income seekers to a punch-packing contributor to younger investors' retirement portfolios.

He argues that the tendency of investors to look solely at the growth rates of earnings, sales and cash flow hurts them in the long run. The bias toward high-growth companies causes them to miss out on the high dividend-paying companies whose total returns, contrary to popular perception, have historically outshined the performance of growth stocks over time, he says.

"Everyone thinks it's old-fashioned to think about dividends, but investors have historically gotten about an extra two or three percentage points a year of higher returns by investing in the highest dividend-yielding stocks and reinvesting the dividends," says Siegel, author of The Future for Investors, Stocks for The Long Run, and other books.

One of his most striking examples is the difference in fortunes between people who invested in IBM rather than Standard Oil, now ExxonMobil (XOM), in 1950. Over the next five decades, through 2003, IBM trounced Standard Oil in per-share growth of revenue, dividends and earnings. But Standard Oil had a higher total return: A $1,000 investment in Standard Oil would have grown to $1.26 million with dividends reinvested, compared to $961,000 -- 24% less -- for IBM investors. "And that was before the recent energy price increases," Siegel says.

While financial companies historically have been reliable dividend payers, the dividends on Fannie Mae and Freddie Mac have been halted, and 21 financial-services firms have cut their payouts since the beginning of this year, according to Standard & Poor's. In a typical year, two or three financial firms cut their dividends, but the majority of them increase their payouts.

Long a supporter of index investing, Siegel now favors index funds that rebalance on a dividend-weighted basis. Siegel is a senior investment strategy adviser at WisdomTree, which has developed a series of funds that operate this way.

A dividend-weighted index rebalances regularly to favor stocks that pay the highest dividend. Most indexed portfolios, in contrast, rebalance based on the market capitalization of the stocks. With a dividend-weighted index, investors end up buying stocks when their prices are low relative to their fundamentals. A high dividend yield is a strong indication that a stock is undervalued, Siegel says.

Throughout history, dividend-paying stocks have gotten the spotlight. When the tech bubble burst in 2000, many investors sought out dividend-paying stocks to try to steady their portfolios. In 2003, payouts got a boost when the tax rate on dividends was changed to the 15% capital-gains rate, versus the higher income-tax rates.

Some of this tax benefit may get rolled back if Sen. Barack Obama (D.-Ill.) is elected president; he has said he would raise the dividend tax rate to 20% -- "but that's still a preferred rate," Siegel points out. He adds that investors who keep a steady spotlight on the high dividend-paying stocks in their portfolios are likely to have a brighter retirement.


Gary Spector
David Darst
Global Wealth Management Group,
Morgan Stanley

David Darst is the Iron Chef of the investment world. As chief investment strategist at Morgan Stanley's Global Wealth Management Group for the past 11 years and one of Wall Street's foremost experts on asset allocation, Darst spends much of his time considering the perfect ingredients -- of a portfolio, that is. He takes a little of this, blends it with a little of that, and -- voilà! -- produces nourishing retirement portfolios.

Investors who have seen the air sucked out of their retirement portfolios lately might need convincing. The problem in the typical portfolio, Darst suspects, is that most people skimp on alternative investments like commodities, real estate and hedge funds.

"The perception is that they're too risky, but we view the benefits of alternatives more by the reduced volatility they bring to a portfolio than by an increased return," says Darst, who recommends that folks with $1 million to $20 million to allocate 20% to alternative investments, and those with less, 8%.

While any particular alternative investment may, indeed, be more volatile than the broad stock or bond markets, a portfolio diversified across stocks, fixed income, and a number of different alternatives will likely be less risky than one with fewer asset classes -- and it may even score higher returns, Darst says.

Consider a portfolio with 40% invested in stocks and the rest split between commodities and real estate. That may sound risky, but according to Ned Davis Research, in the 35 years through 2007, such a portfolio had the same risk as a portfolio with 40% invested in stocks and 60% in bonds. Yet it gained almost two percentage points more per year -- 12.47% versus 10.5%.

Within an alternative-investment portfolio, Darst recommends a 50% weighting in hedge funds, which gives investors the potential to benefit from talented money managers who have the freedom to invest where and how they see fit, without constraint.

Some 20% should be in real assets, such as commodities and gold. Both provide a hedge against inflation, and gold in particular has been a historic refuge in times of turmoil in the financial markets, political instability, or other crises.

Another 20% should be directed to managed-futures funds, Darst says. These invest by going long or short futures contracts in a broad basket of commodities and other investments, including metals, grains, sugar, foreign currencies, stocks and bonds.

Managed-futures funds provide a cushion to portfolios in down markets, because they typically are inversely related to the stock market, Darst says.

During the period 2000 to 2002, when the tech bubble burst and the Standard & Poor's 500 cratered 31%, the Barclay CTA Index of Managed Futures Funds was up 20%. In the fourth quarter of 1987, when the U.S. stock market crashed and the S&P 500 lost 22.5%, the Barclay index was up 13.8%. This year through August, the S&P 500 was down 14%, while the Barclay index was up 6.95%.

Lastly, Darst recommends placing 10% of a portfolio in Treasury inflation-protected securities to get their risk-dampening benefits, Darst says.

While he has usually included real estate in the alternative-investments portfolio through direct investments or REITs (real-estate investment trusts), he predicted enormous volatility in the sector last December and made a tactical move to eliminate real estate from his models.

For the average investor, however, it would take a rare event to prompt the removal of an asset class from the alternative-investments portfolio, because that could mean missing its next surge.

Says Darst: "You want to have all of your relatives at the table. Not just the 17-year-old singer in the family that everyone has always listened to, but the quiet nephew who turns out to win the Pulitzer Prize."

Follow advice like that, and investors themselves just might take home a prize.


E-mail comments to mail@barrons.com

URL for this article:
http://online.barrons.com/article/SB122125832882730055.html




CONTINUED




Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved
This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.



Close