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alternative investments

Second-quarter earnings season has wrapped up, and the numbers were, well, so-so.

Generally, corporate earnings in Canada and the U.S. showed signs of improvement - albeit at a slower pace. It seems like the worst of the financial crisis is behind us - although business and consumer sentiment remain very fragile. The Canadian economy seems healthier than it was a year ago - but serious questions remain about the U.S. and Europe.

Do you see the pattern here?

We seem to be in a "good news/bad news" environment, where both bulls and bears are likely to be disappointed. Unsurprisingly, this kind of tug-of-war is reflected in the movement of the market itself: increasingly range bound, unable to break through established levels, as investors wait for positive news before making a bigger commitment to stocks.

For "long only" investors - those who invest in individual stocks or diversified stock portfolios to capture its appreciation over the mid- to long-term - this is a frustrating time. Until we see crystal-clear signs of an strong economic recovery, most stocks are likely to be stuck in neutral. Investors may have to wait some time (possibly several years) before seeing any tangible appreciation in their positions.

For those who can use alternative strategies, however, the story is much different. For example, investors and managers who can sell stocks "short" - essentially profiting from a stock's decline in value - this kind of market can be very profitable. The same goes for those who can use options, futures, and other strategies to profit from the back-and-forth volatility that we've experienced over the past several months.

To that end, I recently asked a handful of alternative asset managers and executives some point-blank questions on the role alternative assets should play in the high-net-worth portfolio. I hoped they could provide me with a rationale for investing in alternative assets, particularly in light of the challenging investment climate high-net-worth individuals now face.

Scott Morrison, chief investment officer of Wealhouse Capital Management, was the first on my list. "Some money managers have developed skills that are suitable for different [market]conditions," Mr. Morrison told me. By limiting yourself to long-only managers, you limit the kind of market conditions you can make money in.

I asked him to elaborate; he asked me to picture myself as a hockey player. "Imagine other teams were allowed to skate forward and backward, but you could only skate forward," he said. "Imagine you could only use a wrist shot while others could use a wrist shot, slap shot, backhand or snapshot."

Toreigh Stuart was next. The CEO of the Canadian arm of Man Investments, Mr. Stuart started our conversation by noting that many high-net-worth investors have become discouraged with traditional asset classes. "Over the past decade, several of the world's largest high-net-worth investors have realized a portfolio of traditional assets is not sufficiently diversified to meet medium- to long-term objectives," he said.

When I asked him to make the case for alternatives, Mr. Stuart took the direct approach. "Most global equity indices have failed to deliver positive returns over the last five- to ten-year periods," he noted bluntly. The outlook for bonds doesn't look much better: "After years of unsustainable outperformance, traditional fixed-income investments are poised to become a 'low-return' asset class." Especially after a 30-year secular bull market in government bonds.

In such an environment, alternative investments, specifically market neutral and long/short hedge funds, become a lot more appealing. "Equity hedge managers are [taking advantage of]the compelling investment opportunities stemming from the credit crisis," Mr. Stuart notes. "The opportunity for an alternative manager to add value has expanded in-line with volatility."

Dave Picton, president and chief investment officer of Picton Mahoney Asset Management, agreed with this general assessment. When I asked him to justify an investment in alternative assets, he told me a distinction must be made between what he calls "authentic" alternative investments (designed to offer non-correlated performance) and the kind of super-charged hedge funds whose goal is simply to generate outsized returns.

"The original rationale for investing in authentic hedge funds that generate positive absolute returns with little or no correlation to the stock market hasn't changed," Mr. Picton says. "Increased consistency of returns, lower volatility and lower correlation are strong arguments for including [these] in investors' portfolios at all times," he says.

As Mr. Picton explains, the past several months of see-saw stock market volatility provides an even stronger argument for including non-correlated alternative investments in the high-net-worth portfolio. "With equity and fixed income valuations at unimpressive levels, volatility higher than average, and the economic outlook more clouded than normal, it would seem to be an ideal environment to diversify into authentic hedge funds that are less dependent on the stock market to generate returns for investors."

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