After a painful year in 2008, some advisors and investors are falling back in love with hedge funds, but the terms of the relationship are changing.
Bob Kresek got burned by hedge funds. The managing partner in an RIA with about $500 million in client assets under management, Kresek says his clients were hit with a double whammy. Not only did they suffer losses in their hedge fund investments in 2008, but many of them are still waiting for their redemptions checks to come in. The redemption hurdles — not performance — is the reason Kresek's firm, Founders Financial Network, decided to pull all clients out of hedge funds at the end of 2008. But Kresek says it's likely he'll start investing in hedge funds again — on a couple of conditions.
It's not that Kresek feels hedge funds didn't do their job as far as performance goes. “Hedge funds went down less than stocks, so in effect they served part of their purpose, which was to reduce volatility,” he says. His reservations have more to do with how hedge funds are regulated — or, more precisely, not regulated. The funds his clients were invested in allowed redemptions every quarter after a one year lock-up period was completed. But in 2008, when many investors rushed to redeem their investments, Kresek says those quarterly redemption terms were suspended by the managers. (Hedge fund managers may block redemptions if they find it is in the interest of shareholders.) “That's not what I signed up for. Our perception of how much transparency there was and how much oversight we had was shattered,” Kresek says.
There is already legislation in Congress that would require hedge funds to make greater disclosures about the details of their operations. The increased regulation coupled with a recent uptick in hedge fund performance will likely entice some advisors to put their clients back into hedge funds, or even allocate new assets. While some advisors are waiting on the implementation of greater regulatory oversight before making a move back into hedge funds, there are others who are already dipping in.
Of course, there are also those like Jon Goldstein, co-CEO of Constellation Wealth Advisors, a New York and Menlo Park, Calif.-based wealth advisor with over $4 billion in assets, who never lost their enthusiasm for hedge funds. Goldstein says he still views them as an important slice of client portfolios. But his firm has redoubled its efforts to make sure liquidity provisions and transparency issues are well understood. While Constellation did not change its allocation to hedge funds very much over the last couple years (typically 15 to 35 percent in a growth portfolio), the firm has adjusted the hedge fund strategies it is using — these days, clients are allocated to long-short equity, credit, and macro, among others. “We didn't want to pull back completely. As result of the crisis, we just changed which ones worked for our clients. For example, we are trying to work in more liquid hedge funds and fund of funds and those that provide regular exit opportunities,” he says.
Goldstein says some hedge funds have been raising “white flags'' lately. For instance, he says, some funds have gotten more willing to share information with investors. “In a post-Madoff world, investors are much more apprehensive to invest in hedge funds and the managers see that and are willing to be more open about exactly what's in the portfolio,” Goldstein says. Some funds have gone as far to relax their liquidity terms. “Any client seeking to invest with the best possible managers should evaluate hedge funds. Hedge funds attract some of the most talented managers out there, and we remain supportive of them as part of clients' portfolios,” he says.
Hedge Fund Love
After four quarters of net withdrawals, hedge funds recorded net asset inflows in the third quarter of 2009 — adding $1.1 billion in new capital. Of course, the bounce in performance hasn't hurt. The HFRI Fund Weighted Composite Index, which includes over 2,000 funds, gained about 19 percent from January through November 2009, after a record decline of 19 percent in 2008. Specifically, relative value, event driven, and equity hedge funds each returned more than 20 percent over the first three quarters of the year, according to Hedge Fund Research.
RIA firms are responsible for some of these asset flows and some have plans to invest more. In fact, advisors in the RIA channel are most comfortable with alternative investments including hedge funds, according to a recent recent survey by Financial Research Corporation, a Boston-based financial services research and consulting firm. FRC analyst Christopher Yeomans says that's because the compliance departments at large broker/dealers have a propensity to prefer more mainstream investment vehicles. And while wirehouse advisors certainly use hedge funds, “RIAs typically face less red tape in recommending hedge fund products for their clients and with increased use comes increased comfort and familiarity,” he says.
At Fidelity Institutional Wealth Services, RIAs put a significant amount of additional money into the custodian's alternatives products platform last year. According to Ron Fiske, executive vice president at the firm, assets on their alternative products platform grew 50 percent in 2009. Fiske says that's among the most dramatic increases in assets he's seen for a particular asset class. As for next year, in a study of 200 RIAs, more than half of respondents said they plan to increase their allocation to alternatives, including hedge funds, in 2010. “We are seeing an increase in interest among RIAs investing in alternatives like hedge funds. We're seeing a lot of new entrants in the alternatives asset class as well. It's definitely becoming more important again,” Fiske says.
Mark Tibergien, CEO of Pershing Advisor Solutions, says he's also seeing a rising interest in alternatives, specifically hedge funds, among RIAs. “Everyone's operating in a low growth environment right now. As a result, active wealth managers who are serving more sophisticated clients may be looking for greater returns than what mutual funds might be offering, for example,” Tibergien says.
Tibergien believes hedge fund managers are also showing greater interest in retail RIA assets. He says some managers are looking for new sources of capital. “Many managers wouldn't have considered RIA assets a source of significant new capital when the environment for hedge funds was booming. There was no real need to go out looking for capital. But hedge fund managers have felt the same market compression as everyone else, and they're now more open to the idea,” he says.
One New York-based hedge fund manager who asked not to be named says he's taking in assets from RIAs for the first time. Though the RIA assets do not make up a significant portion of his firm's capital (five percent at most, he says), it's something he would not have considered a year or two ago. “In 2008, it was proved that asset managers want a diversified pool of capital. Last year I would have said that university endowments are the best sources of capital. But now I want some of my capital coming from fund of funds, some pensions, some ultra high net worth family offices and some RIA assets,” he says. As Ken Phillips, CEO of HedgeMark puts it, “Traditionally, the RIA community has not been viewed by hedge funds as hot money. But now it's being looked as stable money.” HedgeMark is an an open architecture separately managed account platform for investors in hedge funds.
Phillips says hedge funds will become increasingly popular among advisors — especially RIAs. “The next phase of hedge funds is going to broaden the appeal to a larger base of investors. Hedge fund managers are understanding that RIAs with HNW retail clients can be a good source of serious long term investment capital,” he says. Not only that, but RIAs themselves are becoming less intimidated by the mystery surrounding the investment strategies of hedge funds, he adds.
Meanwhile, analysts believe hedge funds' recovery and improved performance will play a major role in increasing advisors' confidence in the investment vehicles. According to Hedgefund.net, in the first three quarters of 2009, total hedge fund assets increased 1.1 percent, or $20.9 billion. Performance accounted for $258.7 billion in asset growth, while investor withdrawals accounted for net outflows of $237.8 billion. “It is important to note that investor outflows appeared to peak in December 2008 and since then the trend has slowly reversed, led by positive performance. May 2009 showed the first sign that investors were allocating more than they were redeeming with a net inflow of $16.0 billion. Since May, hedge fund investor flows have been net positive for each month through the end of Q3 2009,” states a report by the group.
Of course, not everyone is back on board with the hedge fund resurgence just yet. Consider Schwab Institutional, the leading custodian of RIA assets, which announced in February 2008 that it would no longer accept offshore-fund investments and would stop accepting alternative assets for custody. “While it's true that Schwab is still not accepting any offshore alternative investments nor any new domestic alternative investments, we are continuing to accept new assets in domestic alternatives investments that are already on our platform, provided it passes through our asset acceptance review process,” says a Schwab spokesperson.
Meanwhile, Congress and the SEC are pushing for greater transparency in alternative investments like hedge funds. Last month, the House passed the Wall Street Reform and Consumer Protection Act of 2009, which, among other things, mandates that hedge funds with more $150 million in net capital must register with the SEC. Jeffrey Yager, CPA and partner at New York-based McGladrey & Pullen specializing in financial services, says that would force about 99 percent of the existing 6,500 or so hedge funds to register with the SEC. Today, there are about 5,000 unregistered hedge funds, he says.
It also means that hedge funds would register with the SEC the way RIAs do with a Form ADV. Yager says the exact disclosure requirements for hedge funds have not yet been set, but at the very least hedge fund managers can expect SEC examinations that could last days or weeks (depending on the complexity of the fund). The SEC would likely want to know about the hedge funds' trading activities, whether or not the funds are significantly leveraged and what kind of derivatives exposure they might have. “The House bill says if you've got a fund that's midsized with a simple long-short strategy, it would still have to be registered but the information that it would need to disclose would be different than what another more complex fund would have to disclose. Bigger, more sophisticated hedge funds are going to have to disclose more information,” Yager says.
There are currently other bills in both the House and Senate that aim to increase federal oversight of hedge funds and other private funds. The bills (which include the Private Fund Investment Advisers Registration Act of 2009, Private Fund Transparency Act of 2009, and the Hedge Fund Adviser Registration Act of 2009) differ on certain points (the minimum net capital level for registration, for example) but would all require certain fund managers to register with the SEC under the Investment Advisors Act of 1940.
Currently, managers of privately offered funds use the “private adviser exemption” from registration under the Advisers Act. The exemption allows the fund to avoid registration with the SEC as an investment adviser if the manager advises fewer than 15 clients and does not hold itself out generally to the public as an investment adviser. The existing bills aim to remove that exemption.
While it may not be great news for hedge funds (the Congressional Budget Office estimates hedge fund registration will cost about $30,000 per SEC registrant), it may be good news for advisors looking for information on their hedge fund investments. “It's moving away from the sort of black box of non-transparent environment hedge funds are accustomed with,” Heinz says.
But, of course, registration with the SEC doesn't mean a fund is 100 percent safe. Yager says a thorough SEC examination of a fund is more dependable than simple registration. “I wouldn't get too comfortable just because a fund is now registered with the SEC.”