It is certainly no secret that one of the most important characteristics of a comprehensive wealth management solution is an emphasis on diversification. By owning a variety of asset classes that respond to economic conditions in different ways, a smoother overall return stream can be created. Although this isn't a new concept, the advent of new investment products gives your clients the opportunity to spread risk out more effectively than ever before.
For most investors, diversification consists of owning both of the major traditional asset classes. The benefit of owning stocks and bonds lies in how these two investments relate to one another, since large adverse price changes in one are frequently countered by significant positive moves by the other. Diversification enables clients to withstand the slings and arrows of market movements while remaining fully invested, and as experienced advisors can attest, the greatest gains are made by committing to the markets for the long-run.
For qualified clients, hedge funds are another important tool in the construction of efficient portfolios. For years, hedge funds profited while maintaining moderate correlation to stocks and bonds. But in these difficult investing conditions, when virtually all investments are adversely affected, hedge funds are no exception. The demise and resurrection of the government bailout plan; the fall of Lehman Brothers, Merrill Lynch and AIG; and the precipitous drop in stock prices combined to create an environment of extreme difficulty for most alternative strategies.
Perhaps the greatest impediment to returns was the virtual shutdown of the credit markets. During much of September, banks were unwilling to lend to one another, which made it difficult for businesses to roll-over their short-term financing needs. This resulted in significant markdowns in the value of corporate bonds, which, combined with losses in the stock market, made it nearly impossible to profit during the market turmoil.
And worse, restrictions on short-selling rendered obsolete one of the most important defensive tools in many hedge fund arsenals. Although the rule was temporary, hedge funds could not recover the ground lost during one of the most difficult trading months in recent memory.
However, in the midst of this turmoil we believe that significant profit opportunities have been created--many in the areas most affected by September's harsh conditions. We've seen examples of corporate debt trading at significant discounts and relationships between similar asset classes so out of kilter that savvy traders should be able to profit as conditions return to normal.
As in many market dislocations, investors frequently bolt for the exits irrationally, causing promising strategies to suffer along with the rest of the market. Although many retail investors are fleeing the market for the safety of cash, the best approach is a less emotional analysis of the most compelling opportunities this shakeout will create.
Ben Warwick is chief investment officer of Quantitative Equity Strategies, LLC, in Denver, Colo. and Memphis-based Sovereign Wealth Management, Inc.
