You can't blame clients for getting a little testy when you talk about riding out the storm in the stock market. That was the advice many brokers, sometimes citing the counsel of high-profile firm strategists, doled out at the beginning of 2001. And the results were not gratifying.
Maybe it's time to think alternative investments. That can include anything from precious metals to private equity. But the hottest category is hedge funds of funds, vehicles that let affluent — and less affluent — clients use the various hedging strategies (especially going short) that help the pros make money whichever way the market heads. Indeed, through the first nine months of 2001, the latest figures available, more money flowed into hedge funds, $22.3 billion, than in any prior year, according to Tass Research, a hedge fund tracker.
Of course, performance varies among funds. (When you say hedge fund to the average client, he may immediately think of Long-Term Capital Management, the massively over-leveraged fund that nearly took down the markets when it collapsed in 1998). But, the overall track record is good. The net compound annual return of hedge funds between 1996 and 2000 was 20.4 percent, compared with the 18 percent average gain in the Standard & Poor's 500, according to Van Hedge Fund Advisors International. “They provide absolute returns, regardless of where the market is,” says Rob Rosenbaum, senior vice president and director of domestic sales at Tremont Advisors.
And in down markets, they can be worth the high fees that are typically charged. The Van Hedge Fund Index was up 11 percent through October 2001, compared with a 14 percent drop in the world equity indices. Caveat: Critics say such data are misleading since hedge funds are typically secretive and disclose publicly only what they choose. Indeed, strategists caution that even with improved liquidity and lower minimums, these products are not right for many clients, no matter how wealthy.
The ‘Merely’ Well Off
While many hedge funds restrict their minimum investment to $1 million or more, there are now more funds of funds being created for the merely well off. Clients can get into some funds of funds with as little as $25,000 (although $50,000 to $250,000 is more the norm). The rule of thumb is that it's prudent for investors to restrict their exposure to hedge funds to 5 percent of their wealth. Hedge funds of funds have not only lowered their minimums, but have also, in some cases, reduced the lock-up period (the period in which investors must keep their investment in the fund). In 2000, alternative investments were only 4 percent of total investments, according to Merrill Lynch.
Montgomery Partners, a unit of Montgomery Asset Management, introduced a fund of funds product in December, and plans to offer other venture capital, private- equity and strategic sector funds, including products geared to the high-net-worth people with less than $1 million in assets.
Montgomery will be able to do this because it plans on registering its fund with the SEC as a closed-end fund, enabling Montgomery to bypass limits on the number of investors that it can take.
Oppenheimer, which recently acquired Tremont Advisors, an alternative research house and hedge fund of funds manager, is expected to offer fund of funds products created by that company, and will ultimately look to market to the merely wealthy and their advisors as opposed to the super-wealthy. (In the past, to invest in Regulation D offerings, as fund of funds offerings are often classified, clients had to be “qualified” investors — defined by the SEC as having $1 million or more in assets to invest.)
This year, Charles Schwab is rolling out an opportunity to invest with the New York Private Placement Exchange (NYPPE); all you need is $500,000 or more in assets with Schwab. And UBS PaineWebber has a number of opportunities for clients with at least $500,000 in investable assets.
“Clearly, the traditional asset managers are seeing this as the next big area,” says Bill Santos, managing director of distribution at Montgomery Partners. “In 2002, you'll see more and more companies venture into this space.” It can also be seen as an attempt for Wall Street to diversify its revenue base, while attracting high-net-worth individuals, the most coveted class of investors. Hedge funds and other alternative investments scored high in a recent study of affluent investors by Merrill that asked what products they were most interested (see page 88).
Fund companies, such as Pro Funds and Rydex Funds, have a number of “bear” funds or leveraged offerings that employ hedging strategies as well, but are designed for the average retail client. Increasingly, these products are being offered through wirehouses and independent broker-dealers, rather than being treated as proprietary offerings. Matt McGinness, an analyst at consulting firm Cerulli Associates, says these products are only recently becoming well known by the broader investment community.
“There's certainly an appeal, especially as broker-dealer firms segment their own advisor force to deal with different wealth demographics,” McGinness says. “There's a lot of interest in [hedge fund products] on that side of the business. The providers haven't necessarily dealt with this in the past; it's relatively new.”
Popular Hedge Funds
One of the more popular hedge funds types is the convertible arbitrage strategy, which involves purchasing options in convertible bonds of a company, which can be converted into stock for a pre-arranged price, and simultaneously shorting the common stock. Convertible arbitrage has been the best performing of hedging strategies in 2001, according to Van Hedge Fund Advisors. Long-short equity hedge funds are the most popular, and perhaps the most easily understood, of the hedging strategies employed in the various funds in hedge products. Other strategies include event-driven funds, fixed-income arbitrage and equity market neutral strategies.
Another investment vehicle, while still a hedge fund, is the managed futures strategy, which invests in a variety of global markets through futures, options and currencies. They often also invest in oil and commodities, but increasingly, these funds have turned to financial futures, including fixed income futures. These assets are increasing in popularity as well, although in 2000 they accounted for less than 5 percent of the total hedge fund market, according to Merrill.
But don't fail to think critically when you hear the word “alternative.” The venture capital funds are the poster boys for irrational exuberance, posting negative returns in 2001. The lack of a decent IPO market and the dot-com implosion has forced venture capital firms to write off billions from their portfolios. Although the IPO market is showing some signs of life, only clients with long-term horizons — or a contrarian's mettle — are likely to be interested. Then again, going against the received wisdom is a tried and true path to profits.