Dearth of Easy Pickings?

The smart money believes that once the retail investor gets hold of an investing strategy or individual security, it's time to sell. Sure enough, now that retail investors are able to partake of hedge funds in unprecedented numbers (thanks to the headlong rush to register these vehicles with the SEC), some are calling hedge investing a bubble about to be popped.

That's unlikely to happen for the simple reason that hedge funds are a diverse lot, employing a bewildering array of strategies. The concept of a hedge fund bubble is like saying mutual funds — growth, value, bonds, the whole lot of them — are going to tank. It's not likely that all would fall simultaneously.

That said, there is no denying that when unprecedented amounts of money are chasing a handful of investing strategies, it's time to get careful. As of 2004, assets managed by hedge funds reached the $1 trillion mark by some estimates. And some strategies — such as macro and merger/arbitrage — have been forced into risky private placements in a quest for higher returns. At the same time, other strategies, such as distressed debt, may have their best days behind them. Manager selection, then, assumes great importance — which is why broker/dealers prefer that their advisors invest in funds of funds rather than in individual managers.

Hedge Funds for Everyone

The space is still dominated by the super rich, but is moving downstream: 55 percent of hedge fund assets come from high-net-worth households (with investible assets over $5 million) and family offices, according to Chip Roame, managing principal of Tiburon Strategic Advisors, which provides market research and consulting to the financial services industry. Those investors make up a significant portion of funds of funds assets, too, which account for another 19 percent of the market. Endowments, foundations and pension funds make up the rest.

Now hedge funds are moving down to the emerging affluent market ($1 million to $5 million in investable assets). Penetration in the high-net-worth retail space is still low (less than 5 percent of hedge fund assets), but Roame sees great potential. “You will see a huge movement of alternative investments downmarket into emerging affluent households through all of the advisor channels, through the full-service brokers, through the independent brokers and through the fee-only advisors,” he predicts.

For now, reliable information on assets flowing via the financial advisor/broker channel is not readily available. Most investments are privately placed and the SEC restricts advertising and solicitation even for registered funds, so firms are reluctant to discuss specific products. Some data are available, however. UBS has launched nine registered funds since 2000 that have attracted about $3 billion so far. Other wirehouses, including Morgan Stanley, Oppenheimer and Smith Barney, have registered funds of hedge funds, too. Raymond James Financial Services now offers 10 different alternative investment families, up from three or four funds in 1998, says Fred Wahlen, who runs RJFS' alternative unit. On the independent front, LPL Financial Services and Charles Schwab & Co. are both planning on increasing their offerings in 2005.

An AdvisorBenchmarking survey conducted last year among independent registered investment advisors found that 16.5 percent used hedge funds in 2003 and 39.4 percent were considering doing so, up from 15.3 percent and 37.8 percent, respectively, in 2002. Not surprisingly, interest is skewed toward larger advisors: 31.2 percent of those who managed $500 million or more used hedge funds in 2003, compared to just 6.9 percent of advisors managing less than $50 million. The survey did not include the question in earlier years and did not cover the wirehouse rep community.

Chasing the Hot Dot

What gives credence to the bubble theory is that hedge fund strategies delivered lackluster performances compared to historical returns (see table on page 65). But advisors shouldn't dwell on returns per se; hedging is, as the name implies, about mitigating risk. “I'm not sure performance chasing is ever a smart thing in our arena,” says Brian Clarke, head of sales for the Americas at Refco Alternative Investments, which specializes in managed futures. “What most clever investors look for out of hedge funds is an extraordinarily high-level approach to extracting value out of the markets. It is the purest approach to investing in terms of defining and managing risk.”

Indeed, hedge funds, once a proxy for equity-type returns, have moved toward fixed-income investments over the past 10 years, according to Phillip Maisano, chairman and chief executive officer of EACM Advisors, a fund of hedge funds manager based in Greenwich, Conn. “The absolute return projections have come down, and I think they have been accepted in the marketplace because these strategies are different enough than traditional portfolios to still have a place.” He says, “The premise has changed, but the noncorrelation benefits should be relatively the same.”

Maisano believes macro funds have become less attractive as they have moved into what he calls “something close to private equity” in order to enhance their returns. “We have a pretty firm prejudice that private equity is equity, and, at the end of the day, it's going to correlate pretty closely to the equity market,” Maisano says. But, long equity exposure, even if indirect, dampens the noncorrelated diversification benefit hedge funds can provide.

The quest for higher returns has even driven some arbitrage hedge fund managers to accept the risks in private placements. “It's much more difficult to hedge those, and if they need to trade out of those positions, I don't know how they're going to do it,” says Maisano, who nevertheless notes the ploy has paid off so far. “They've added some risk in what formerly was an area where there wasn't much risk, and it was a very controllable kind of risk,” he says.

Hedge funds focused on distressed securities, which have delivered great returns for the past two years, may be running out of gas. “Credit spreads are very tight, and it's been a very good run,” says John Rowsell, president of Glenwood Capital Investments. “There's been a huge issuance of high-yield debt. I think short term the risks are skewing against distressed. The seeds are being planted for another great run a few years from now.”

Money has flowed into equity-based hedge funds, including equity long/short, distressed and merger arbitrage, according to Clarke. “Merger arb is coming out of its doldrums, where everyone was in the same 10 to 12 opportunities because there were only 10 to 12 opportunities out there.” Whether increased merger activity will translate into higher arbitrage returns is less clear. Meanwhile, hedge funds have emerged as major players in the early-2005 merger boomlet.

Many merger arbitrage funds have extended into other event-driven opportunities, an area Rowsell finds attractive. “I think the amount of corporate activity you're starting to see all of a sudden is indicative of a growing set of opportunities,” he says, “It's not pure merger arbitrage.”

Long/short equity funds have delivered double-digit returns for two years straight, but Maisano thinks they will continue to prosper. “They're a harder pick because you have to get better operators to do that, but there's also not much of a capacity constraint when you find them,” he says, “There's always something to do.”

That's partly because different styles fall under the equity long/short umbrella. “You have so many choices — you can go safe, or you can go out on a limb,” says Joe Aaron, president of Wood Hat & Silver, a registered investment advisor in Napa, Calif., “Usually they yield more than the various arbitrage strategies.”

Glenwood believes managed futures and macro players will find opportunities in currencies and interest rates over the next year or two. “The economies across the world have been quite synchronized in a steady growth level,” says Rowsell, “We look at what's going on in terms of balance of trade and so forth. That could be a very interesting play. But those are more trading-oriented managers.”

The lines between hedge fund categories are blurring as specialist managers — frustrated by low returns — switch to a multistrategy approach. That complicates allocation decisions for funds of funds. “We're skeptical of their ability in strategies other than their expertise, but we've seen a good bit of that,” Maisano says, “If you have great confidence in the manager and in his original strategy you might stick with him because you don't want to lose his expertise when his category comes back.”

What should reps do when qualified clients ask about hedge funds? First, make sure clients don't expect returns will shoot the lights out. Focus on the benefits of noncorrelation, diversification and capital preservation and explain that performance is not the best reason to own hedge funds. Then look — hard — at what the hedge funds or fund of funds the clients are interested in are doing, what strategies they pursue and who the managers are. Make sure clients understand the lack of liquidity, too. As more money enters the industry and manager selection becomes more important, top managers are locking up investors' capital for longer periods.

Reps who educate clients about the risks are less likely to jeopardize their relationships if the returns prove disappointing. Hedge funds can still add value to portfolios, but in a more discriminating market reps must recognize the dispersion of returns within each strategy is likely to increase. “How well you select the manager is going to matter more next year than it did last year and the year before,” says Maisano.