Are hedge funds the next bubble to burst? If you read general interest business magazines, you might think so. In October, for example, Forbes repeated its assertion, made a year earlier in a cover story, that hedge funds “charge outrageous fees, deliver mediocre returns and in some cases cross the line into illegal activity.”

Other stories have pointed with alarm to a potential bubble as money pours into these vehicles, which may use various strategies, including shorting and leveraging, to achieve speculative-like returns, regardless of the direction of the overall market. Last year 7,000 funds had about $600 billion under management, according to Van Hedge Fund Advisors International.

Certainly hedge funds have earned a degree of infamy: It was only four years ago that the implosion of the over leveraged Long-Term Capital Management threatened to take down the U.S. banking system. The cachet of hedge funds — loosely regulated, highly secretive operations used by wealthy individuals and institutions — created an aura of mystery and suspicion of shady methodology.

However, today, hedge funds are offered to less affluent investors through firms such as CIBC Oppenheimer, Charles Schwab, Goldman Sachs and State Street Global Advisors and others. New products are constructed so that they require investments of $25,000 or even less. Why? So they can be more affordable to the average investor. Hedge funds are rapidly losing their status as the preserve of super-rich investors with deep Wall Street connections. (To get around rules that allow only qualified retail investors and institutions to investß, hedge funds have been registering with the SEC. In this way, they can mass-market themselves.)

In light of these trends, the SEC in May launched a formal fact-finding investigation into the hedge fund industry and other lightly regulated investment pools. Chairman Harvey Pitt said the inquiry would focus on fraud, conflicts of interest on the part of fund managers and the marketing of private funds directly and indirectly to retail investors. The report is scheduled to be released by the end of the year.

With all this negative attention, advisors might be tempted to regard these investment vehicles as too wild for their clients. Do you even dare bring this kind of investment up for your clients if the SEC is investigating the asset class?

The truth is hedge funds have been criticized as much as they have been lionized over the last decade (remember the amount of ink spilled on Soros' “breaking” of the Bank of England in 1992 and the resulting fortune it earned him? Remember, too, when Soros was trapped with too much exposure to tech in 2000?). We at Frank Russell would argue that despite the SEC's investigation, hedge funds are an excellent asset class, since they often offer non-correlated absolute returns. (Full disclosure: Frank Russell advises institutional and high net worth clients on hedge-fund strategies.)

Here's why any rep with high-net-worth clients ought to become familiar with the nuances of hedge funds.

First, it is impossible to generalize when talking about hedge funds. True, a few funds have crossed the line into illegal activity. Yes, the performance of some has been mediocre. And, indeed, some might charge outrageous fees. However, such statements are not true of all hedge funds, nor are they necessarily true of the majority of funds. Hedge funds are diverse in structure, objectives and strategies. Performance, fees and risk vary widely, depending upon the strategy employed. Also, not all are wildly risky investments; most do in fact use hedging strategies to reduce risk.

It also is very important to realize that hedge funds are not, strictly speaking, a cohesive asset class. You cannot say, “hedge funds performed well today,” in the same way you can say, “real estate funds performed well today,” or “corporate bonds advanced.” Such generalizations are impossible when you consider the different hedge funds' strategies and objectives.

Indeed, many hedge funds are hard to stereotype. Although indexes based on hedge fund performance do exist, they are simply an attempt at picking a universe of managers who may, or may not, be representative of the performances by all hedge-fund managers of that style. To talk of a “bubble” as though all hedge funds were the same is, therefore, misleading.

Investor success results entirely from picking the right managers. It is not a strict asset-allocation decision. Hedge funds involve all existing asset classes, including stocks and bonds, and are all about investment strategies. In this way, hedge funds are unlike mutual funds, which obtain most of their returns from the market. Most of the returns for hedge funds derive from strategies followed by an individual manager. After all, the whole purpose of a hedge fund is to hedge out exposure to the market. The investment is in the fund manager, in his strategies and in his ability to generate a return in different market environments.

It also is not meaningful to generalize and say hedge funds are high- or low-risk vehicles. High-profile losses do not mean all hedge funds are high risk. They vary widely in terms of risk as well as in performance goals. Indeed, some are far less risky than the stocks in the Russell 1000 index. For example, many of the market neutral and arbitrage strategies exhibit far less volatility than equity indexes do.

Management fees usually hover around 1 percent, but often take about 20 percent of the profits. Yet our research has shown that, historically, most funds have earned sufficient returns to justify those fees. Like anywhere else, diversification is essential. The best way to invest in hedge funds is through a fund-of-funds product that includes at least 15 (perhaps as many as 30) different hedge funds within a portfolio.

Remember that hedge funds tend to lag equities in a bull market, but tend to hold up better in a bear market. Average investors should have at least 5 percent of their net worth invested in a hedge fund-of-funds product. Any smaller investment will have a minimal impact on the portfolio.

Over time you likely will develop a comfort zone with hedge funds. A lot of high net worth individuals have been investing in hedge funds for a long time. Most still are. Those who understand them, and invest accordingly, find they are a useful additional means of diversification in a well-structured portfolio.

Writer's BIO:
Dave Tsujimoto
is director of alternative investments at Frank Russell. He researches and analyzes alternative investment strategies and manages hedge fund portfolios.
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