May 2, 2001

Consider the Alternative

When the bears come out of the woods, the best wea

There's nothing like a down market to make the case for hedge funds. With many of them offering investment returns that are not correlated to the broad equity market, many advisors stashed clients' assets into hedge funds long before the Nasdaq, Dow, and S&P crumpled. Now they're basking in their clients' thanks.

The sheer growth of hedge funds over the past decade bears out the tremendous popularity of this asset class. Hedge fund assets are now estimated to exceed $400 billion. A recent report released jointly by Tremont Partners Inc., a financial services company specializing in hedge funds, and Tass Investment Research--a Tremont subsidiary and hedge fund consulting firm--says that over the past 10 years, the number of hedge funds has increased at an average rate of more than 25% per year, for a total growth of 648%. This phenomenal growth is attributed to the growing number of talented mutual fund managers who have launched hedge funds. "You can't ignore a half-trillion-dollar asset class," says Jeff Joseph, managing director of HedgeWorld, an online hedge fund site. "Many advisors have seen their asset bases decline more than 25% this year. That really is a wake-up call."

Mindful of everything from the past triumphs of George Soros and Julian Robertson to such fiascos as the near-collapse of Long Term Capital Management, the Wall Street Journal often refers to hedge funds as "high-flying investments." But "the vast majority of hedge fund strategies are extremely conservative and have substantially less volatility than the S&P 500," Joseph says. "They're absolute return strategies with very low standard deviations."

Don't Forget the Risks

Not that hedge funds don't have risk. Patrick Moriarity, executive vice president at Evaluation Associates Capital Markets in Norwalk, Connecticut, says, "The beauty of a hedge fund is that you are taking away market risk, but adding in other risk. The risk is typically the manager risk, which is very large, and strategy risk." And that is why investing in hedge funds is not as simple as buying a mutual fund. Before recommending a purchase, you need to know about the role hedge funds play in portfolios; their legal structure, redemption, and subscription and liquidity differences; the structural risk inherent in a private investment; and the ins and outs of hedge fund investment strategies. Remember, too, that hedge funds are not for everyone. Unlike mutual funds, they are not regulated by the Securities and Exchange Commission, so an investor has to be defined as "qualified," usually meaning an annual income greater than $200,000 for the last two years or $1 million in investable assets.

Tremont and Tass identify 11 primary investment categories in the industry: Long/short equity; equity market neutral; equity trading; event driven; convertible arbitrage; fixed-income relative value arbitrage; global macro; short sellers; emerging markets; managed futures; and funds of funds. The latter is p

Hedge Funds on the Web
While getting information on hedge funds and hedge fund managers is not as simple as researching mutual funds, there are resources on the Internet that can get you started.

HedgeWorld

www.hedgeworld.com

Managed Account Reports

www.marhedge.com

Tremont Advisers

www.tremontadvisers.com

Tass Investment Research

www.tassresearch.com

Evaluation Associates Capital Markets

www.EACMalternative.com

Hedge Fund Association

www.thehfa.org

HedgeFund.net

www.hedgefund.net

erhaps the most popular type of hedge fund for advisors and early adopters because it's the industry's closest equivalent to a mutual fund. Like a mutual fund, a fund of funds portfolio is less risky than a single fund investment because it invests in multiple hedge funds--from five to 100--with different styles. Clients also get access to the best talent, which is crucial, because some hedge funds' minimums are too high for most individual investors.

Tremont, for example, offers the American Masters Series funds of funds, each with 10 managers. In the lowest-risk category is the Market Neutral Fund, a multistrategy fund with no market direction that's positioned to be a supplement to fixed-income. The Opportunity Fund has a long/short equity strategy with some risk arbitrage, and is designed to have half the volatility of the Standard & Poor's 500-stock index. The most aggressive is the Multi-Tech Fund, a sector fund with a long/short strategy and half the volatility of the Nasdaq 100 index.

Making Markets

But making the critical decision to choose one management group's funds over another is not easy. Unlike stocks or mutual funds, there is no central marketplace for hedge funds. And hedge funds are not allowed to advertise. As Charles Schwab revolutionized the mutual fund industry in 1992 when it introduced its OneSource platform offering access to a universe of mutual funds, HedgeWorld is planning to unveil a distribution platform and global online hedge fund marketplace called FundSelect. The marketplace, says Joseph, will offer advisors a "seamless, integrated, end-to-end solution" that starts off with the manager selection process. Advisors will be able to see, for instance, the effect of allocating 8% of a $5 million client portfolio to hedge funds. The advisor could then tap into a universe of hedge fund products, and search for the ideal strategies using portfolio optimization tools. The tools will allow an advisor "to see what the impact of adding 5% of a merger arbitrage strategy would have on a traditional portfolio of 60% stocks and 40% bonds," Joseph says. FundSelect will also allow advisors to perform due diligence on different hedge fund managers. HedgeWorld (www.hedgeworld.com) plans to launch its offshore fund platform in the second quarter, and the U.S. platform in the third quarter.

HedgeWorld is hardly alone in offering new hedge fund products. Many asset management companies serving registered investment advisors and high-net-worth clients are also catching on to the hedge fund craze.

HedgeWorld says SEI Investments, for one, is researching creating manager of managers or fund of funds products, including hedge fund and private equity asset classes. And Zurich Capital Markets Inc., a unit of Zurich Financial Services Group, is launching a family of hedge funds and hedge fund indices based on more than 20 managers. Zurich Capital Markets also recently purchased Managed Accounts Reports' hedge fund and managed futures databases.

Who's On Top
Three Wall Street firms dominate the hedge fund business, a new survey finds

A new survey by HedgeWorld of 1,000 hedge funds found that Morgan Stanley, Bear Stearns, and Goldman Sachs were the largest brokers in assets and number of funds served. The survey, conducted by The HedgeWorld Research Institute, revealed that the three firms served as primary brokers to more than 70% of the nearly $100 billion in assets of the 998 single-manager hedge funds polled.

The full results of the HedgeWorld survey will be released later this spring as part of a comprehensive hedge fund reference guide called, "HedgeWorld Annual Compendium 2001." The compendium will also include information on four other categories of hedge fund service providers: administrators, attorneys, auditors, and custodians.

"You can't just look at these prime brokers as bean counters," says Matthew Sola, a HedgeWorld spokesman. "Hedge funds outsource their back office, so they need a heavy hitter" like a large brokerage firm. The survey tells the story that "a lot of people are working hard to make [hedge funds] a business."

According to the survey, Morgan Stanley Prime Brokerage serves 210 of the 998 funds and accounts for $32.6 billion in assets. Second-ranked Bear Stearns Securities Corp. services 187 funds with $22.3 billion in assets. Goldman Sachs & Co. came in third with 143 funds and $15.6 billion in assets. Merrill Lynch Prime Brokerage ranked fourth with $6.5 billion in assets, and Banc of America Prime Brokerage followed with $4.23 billion.

Morgan Stanley ranked as the most popular prime broker for the largest funds in the survey--those with more than $1 billion in assets--and serves 8 of the 15 such funds. Of the smallest funds in the survey--those with $10 million and less in assets--the top three brokers, in order, are Morgan Stanley, Goldman Sachs and Bear Stearns.

The survey also revealed that Bear Stearns is the primary broker most frequently cited for managers specializing in fixed income, convertible arbitrage, market neutral, and event-driven strategies. Morgan Stanley was the most used prime broker for global macro and long-short strategies. ED&F Man (the London-based futures broker which just changed its name to Man Investment Products) was the top choice for managed futures players, and ABN Amro was chosen most often by short sellers. --Melanie Waddell

The Wealthy Want Them

Advisors latch onto hedge funds for many reasons. Joseph, who was previously a principal in a planning firm, says when his firm grew to managing $250 million in discretionary assets, the clientele became more sophisticated and wealthy and started asking for alternative investments. "That's a pretty typical scenario," he says. "At that asset level, that's when alternative investments become very real." But firms don't have to be that large to start considering hedge funds. Other reasons could be the drive to stay competitive, or market pressures. An advisor may recognize the old 80/20 rule--80% of the revenues come from 20% of the clients--and find that the 20% is requesting alternative investments. Some planners offer hedge funds as tools to attract high-net-worth clients. And one planner is so fed up with errors in mutual fund transactions and confusing statements, that he's allocating more of his clients portfolios to hedge funds (see sidebar, page 50).

Tom Gnuse, president of the $40 million HTG Investment Advisors in New Caanan, Connecticut, says his firm has been interested in hedge funds for some time, and he's found them to be more accessible now. He recently placed a number of clients in hedge fund of funds strategies with a $250,000 minimum to replace more volatile fixed-income and equity strategies. "Our view," he says, "is that an investor who uses hedge funds should be using a variety of hedge fund techniques implemented by a specialist," such as the fund of funds strategy.

Gnuse uses funds with strategies including commodity futures, merger arbitrage, convertible arbitrage, long/short market neutral and long/short equity, he says. "We use those when we want to add 10% to 20% in alternative investment into a portfolio." He says a large portion of his clients have 5% to 20% of their portfolios allocated to such alternative assets.

When considering private equity or venture capital, Gnuse says these investments are illiquid, compared with hedge funds, because they are private securities that are not priced daily. "Private equity and venture capital investments are suitable for a smaller number of people than hedge funds are," he says. It takes a "pretty high-net-worth individual who can take these placements."

A Job Well Done

After starting a fund of funds in late 1995, Tim Kochis, of Kochis Fitz, a wealth management firm in San Francisco, says he couldn't be more satisfied with its performance: "It's doing the job--producing good returns in bad times." He says March's return figures were up, and for the first quarter, the fund gained between 3.5% to 4%. His fund has 15 clients invested in it, but it carries a high minimum threshold of $500,000.

Lou Stanasalovich, a planner with Legend Financial Advisors in Pittsburgh, says his firm created a fund of funds a couple of years ago using various versions of "lower volatility portfolios." The fund of funds includes the Merger Fund, a fund that uses an announced merger arbitrage strategy--which is a hedge fund-like technique that Stanasalovich says lacks the risky leverage involved in most hedge funds. The fund also uses the Coldwell & Orkin Market Opportunity Fund, a domestic long/short fund, as well as the Leuthold Core Investment Fund, "a tactical asset allocation fund." These funds were combined to create multiple versions of "lower volatility portfolios," he says. For five-year performance at year-end 2000, the S&P 500 was up 18% with a standard deviation of 19, Stanasalovich says, and the various versions of the lower volatility portfolios are returning 15.5% to 17% with a 4 to 6 standard deviation. "So these funds are returning near the S&P with a third of the risk." Stanasalovich says about 35% of his clients are in the fund of funds, and he's looking to allocate more client assets to a fund of funds product being created by Undiscovered Managers in Dallas.

Mark Spangler, a planner with the $110 million Spangler Financial Group in Seattle, began allocating clients' assets to a fund of funds that he started a little more than two years ago. In 1998 when the market and technology stocks were booming, he started hedging against a possible downturn with his fund of funds strategy. His fund of funds has a "couple million dollar minimum," and nearly all of his 25 clients have a portion of their portfolio in it. Year-end 2000 results for the hedge fund portfolio was "67% positive," he says, and year to date it's "18% positive."

Spangler says advisors should stop dodging hedge fund strategies and start learning more about them. "Advisors must go through the due diligence needed to find out about hedge funds," he says. "A lot of advisors have either done nothing or have postponed dealing with it by saying, 'Well, look at what happened to Long Term Capital Management.' They have to take some time out and learn about hedge funds."

The First Step

"It's a hard argument for me to understand someone saying that hedge funds are too risky. [Advisors] will get into a Janus fund and see it lose 50% of its value. I've never seen hedge funds do that," Spangler says. "What has happened in the last year in the markets will push advisors into hedge funds."

In the venture capital and private equity arenas, Spangler says VC deals are priced better today than in previous years. "We dabble in venture investments--early seed venture capital. It's another arena hopefully away from the public arena." These types of alternative investments are out in left field for advisors, though, he says. "In the alternative arena, the first step will be taken in hedge funds."

The Fund of Funds Approach
Bill James, a planner with Capital Advisory Group in Tampa, Florida, who serves a "specialized" group of nine very wealthy clients, says his increasing frustration with mutual fund statements and transactions have prompted him to shift assets to hedge funds. "I've had clients receive a statement at home with their name on it and their fund name and under that [information], it has the name, account number and current values of strangers' accounts," he says. "It's a serious problem."

James also dislikes the lack of standardization in mutual fund reporting. Take a client with assets at five different fund companies, he says. Each company's statement will be laid out differently, making life confusing for clients.

With $45 million in assets under his supervision, James says he's putting clients into Tremont Partners' American Masters Series fund of funds because "they are specialized to look at risk-adjusted returns and have a heavy emphasis on reducing client risk. This is the best [fund of funds] I've seen so far." The Tremont fund of funds include the more conservative Market Neutral Fund, and The Opportunity Fund, which James says is designed to have a maximum 40% volatility of the S&P 500, "and yet it was able to pull off 16% [return] in last year's environment." The more aggressive Multi-Tech Fund, which James says he uses "only in larger portfolios and those with appropriate client risk tolerance levels." In 2000, the Multi-Tech Fund showed a 23.5% return following a 62% return in year-end 1999, he says. "On the downside in a poor year [the Multi-Tech Fund] delivers an excellent rate of return."

James says one of his longest-standing clients bought an equal amount of all three Tremont funds, and was "astonished that in February, when the Nasdaq was down around 26%, the Multi-Tech--the highest risk--had slipped only 4%."

Spangler says he likes to use Managed Accounts Reports' database of hedge fund managers and HedgeWorld's Web site. More and more hedge fund resources are popping up every day, and Spangler expects this to spark increased use of the alternative asset class. "We'll see a duplication of what happened with mutual funds and Morningstar," he says. "Until Morningstar, there wasn't easy to access to mutual fund information."

Jack Blankenship, a planner with Blankenship & Foster in Del Mar, California, allocates his wealthy clients' assets into an alternative investment called an unmanaged futures pool. The pool uses the Mount Lucas Management Index of 25 different futures markets, with a 4% investment in each of the 25 indexes. Because the investment is unmanaged, he says, "It provides a way to be sure you get close to the index of the commodities. You don't want to stray too far away from the index." MLM has been providing the index for about 15 years, Blankenship says, but has only recently started providing an investment based on the index. "It's a way to get a well-diversified investment into clients' portfolios." Since Blankenship started using the futures pool last year, it's up 22%.

Ben Warwick, chief investment officer at Sovereign Wealth Management, Inc., in Denver, Colorado (and an Investment Advisor contributor), is also creating a fund of funds. But he advises using caution before you jump into the hedge fund arena. Indeed, you don't just want downside protection from a fund. "We try to look at alternative investments that do well when the stock market goes up," Warwick says. "If you isolate just the months the stock market is going down, a lot of hedge fund styles are correlated. They are correlated when you don't want them to be correlated just because of the contagious nature of volatility."

Says Warwick: "You have to have the right reason to get into hedge funds." For some people, "a lot of the reason is that it is the 'it' investment, but you have to look at it from a top-down perspective, and know how will it affect clients' portfolios." The idea, of course, is to help investors diversify their holdings and create buffers against the kind of shocks that have been rocking stock markets for more than a year. After all, that's why they call them "hedge funds."

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