Let Us In

Three years ago, at the height of the equities run-up, investors had little reason to be interested in hedge funds. The intervening years have brought with them some important lessons about diversification, and this has made alternative investments — those that are uncorrelated with the stock market — a more attractive option.

At the same time, the most high profile of alternative investments — hedge funds — have been changing to broaden their appeal and to attract more investors, in part through the use of registered funds, which have a lower cost of entry than their unregistered brethren.

The combination of these forces is making hedge funds a more mainstream investment than they've ever been before — a good thing, because a rising number of previously excluded retail investors want in.

What's the difference?

According to three separate studies conducted by Prince & Associates, investors are acutely interested in hedge funds. Diversification benefits and exclusivity are part of the attraction, but most of all, investors are drawn by the chance to have their money in the hands of managers who they see as the very best in the business.

Indeed, hedge funds offer investors a number of key benefits, including lower volatility, higher Sharpe ratios than stocks or bonds and, often, good track records when compared with the S&P 500.

For example, in 2002, a rough year for the S&P 500, 659 of the 685 hedge funds reporting returns beat that index, according to MAR Hedge, a New York-based industry database. Meanwhile, 450 finished either flat or in the black. However, to generate enough money to make the fund profitable, the ante is set high — usually $500,000 or more.

Even with that steep cost of admission, there has been a sharp increase of takers. In 1990, global hedge fund assets sat at $60 billion. Today, spurred in no small part by the brutal bear market, that number has ballooned to $750 billion in about 7,000 hedge funds worldwide.

In a study of the hedge fund industry conducted in 2002, Financial Research Corp. predicted that trend line would continue to point upwards. FRC predicts hedge fund assets will hit $1 trillion (in over 9,000 funds) by the end of this year.

Registered Funds vs. All

One factor in that expansion has been the growth of registered funds. These have a number of differences from the traditional (unregistered) hedge funds.

Unregistered funds — which aspire to minimal levels of accountability and scrutiny — are accessible only to “qualified” investors, who typically have over $5 million in investable assets.

By contrast, registered funds look downright egalitarian, requiring a net worth of $1 million or income of over $200,000 in the two years preceding investment. Despite all the talk of “retail” hedge funds and democratization, the cost of entry into registered funds is still relatively high — $25,000 to $250,000. Still, this puts them well within shooting distance of the mass affluent investors coveted by many advisors.

Being registered also translates into SEC oversight, which makes a fund more accountable, but also less nimble.

Finally, registered hedge funds can be marketed and promoted in ways that unregistered hedge funds cannot, which can make it easier for advisors to sell them.

There are also some important differences between a registered offering, such as a fund of funds, and an open-end mutual fund. (A fund of funds, the most common type of registered hedge fund, invests in a number of hedge fund strategies and in a number of managers, typically from 15 to 25.)

For instance, there are many more managers per fund for the former — so many, in fact, that an investor can be said to be investing in managers themselves, rather than in securities. Further, there's less liquidity and, as a rule, no redemption rights with registered hedge funds. There also can be incentive fees, which appeal to investors who believe the best managers should reap rewards for their success. (Note: Incentive fees translate into higher net-worth requirements for investors — $1.5 million rather than the usual $1 million.)

Our Survey

We've been researching how affluent investors feel about hedge funds since 1999, when the stock market was still soaring. Our initial survey consisted of 267 investors with incomes of $100,000 to $500,000 and a net worth of $500,000 to $1 million — a group traditionally shut out of hedge funds. We revisited the survey in 2001 (301 respondents) and again in 2003 (288 respondents), and we found that investors' attraction to hedge funds is intensifying year over year.

The top reason for investing in hedge funds cited in each of the studies was the perception that they were home to the most talented investment managers. Indeed, investors increasingly view hedge funds as the ultimate destination for the best managers, with over 90 percent indicating as much in the 2003 survey.

The second attraction of hedge funds is their diversifying properties — an attribute investors understandably value a bit more now than they did in 1999.

When it came to issues of access to hedge funds, the news was positive for registered funds. The percentage of surveyed investors who would invest in registered funds if they had the opportunity rose to 86.5 percent (from 62.2 percent in 1999.)

The investors also are convinced that hedge funds would soon be available to less wealthy investors such as themselves — a move many apparently favored. In the 2003 survey, 77.1 percent of respondents said they had been unfairly priced out of hedge funds, and almost the same percentage thought that investors of every stripe should get the chance to invest in them.

When mutual funds became more popular, there was the fear that they were too arcane to be understood. We all know how that one turned out.

Now, investors want to be educated about registered hedge funds, and, over time, they will be. Their desire to park money with the best managers available should be incentive enough for advisors and investors to bone up on hedge funds and to begin dabbling in them, if they haven't already.

The demand is there, and the question confronting the financial services industry is how long it will take to innovate and find the right combination of vehicles, pricing and features to feed the appetite of this market segment.

Writers' BIOS: Russ Alan Prince is president of Prince & Associates.

Hannah Shaw Grove is managing director at Merrill Lynch Investment Managers.

Talking Over the Hedge