From the December 2005 issue of Investment Advisor • Subscribe!

December 1, 2005

Transatlantic Teachers

Hedge funds are big news in the U.S., but old news in Europe. What can we learn from Europe's approach to hedge funds?

Like most European financiers, Johan Olson, investor relations manager at private bank Mirabaud & Cie in Geneva, Switzerland, doesn't bat an eyelid at the mention of hedge funds.

"We have used hedge funds-of-funds as a tool to diversify and decorrelate traditional bond and equity portfolios for 30 years," Olson states, coolly. "We have a track record of doing this, and our bank would not have 25% of its clients' money in hedge funds if this strategy did not work."

Call it blas?(C), but this approach is not at all unusual in Europe's financial community, where hedge funds have long been a part of the portfolios of high-net-worth individuals. For decades now, European advisors have been recommending and investing in all manner of hedge funds for diversification and portfolio enhancement, and using these vehicles has become part and parcel of mainstream investing.

In the United States, by contrast, most financial advisors, brokers, and investors are still wont to think of hedge funds as complex, dangerous, and volatile instruments that are hard to figure out. Even if they acknowledge the great potential hedge fund investing has to offer, many financial advisors in the U.S. just do not have the same comfort level vis-? -vis hedge funds enjoyed by their European counterparts. Indeed, advisors like Hemant "HP" Singh, chairman of the New York-based firm Private Wealth Management believe hedge funds are more pain than pleasure, and as such, would rather not get involved with them at all.

"The term 'hedge fund' in its origin meant a fund that is capable of hedging risk and reward in order to successfully manage and take advantage of the volatility of the market," Singh says. "I do not consider hedge funds for our clients because I do not believe that they have served that purpose. They can be difficult to understand and expensive, and are usually involved with seemingly sound but very complex strategies that I have found to be not worth the expense nor the risk for my clients."

So, then, what's the origin of Europeans' confidence in hedge funds?

Just Another Asset Class?

Some say that comfort level arises from the way in which the Europeans view hedge funds. Rather than thinking of them as a category of investments unto themselves, a rare breed of investing vehicle to be approached only with the utmost caution, the European financial community has instead considered hedge funds an asset class like any other, looking upon them as just another means to diversify and enhance a portfolio of investments.

"We don't look at hedge funds as a separate asset class, but rather, as just different strategies of managing bonds and equities," Olson says. "This has allowed us to include [hedge funds] in our asset allocation models, all the while managing money on a discretionary basis with the objective of preserving capital."

While some might think that this approach is reflective of an investor base that is far more sophisticated than its U.S. counterpart, the dichotomy is not so simple, and one needs to probe deeper to see that the prevailing attitudes are a result of the historical and structural differences between Europe and the U.S. Although the United States is the largest hedge fund market in the world, there are several factors at play that have held back the more widespread acceptance of hedge funds as viable instruments for portfolio diversification, says John Kelly, president and CEO of Man Investments USA, and these continue to play a role in determining the level of acceptance of hedge funds.

While in Europe the use of hedge funds to enhance portfolios of individual clients has been a common practice for players from large banks to smaller, boutique firms, hedge funds in the U.S. were always the domain of truly wealthy investors, Kelly says. They were reserved only for a class of uber-rich individuals with gargantuan fortunes, who were as financially sophisticated as their high-end advisors, and fully understood both the complexities and the benefits of investing in hedge funds. Therefore, hedge funds were offered exclusively to this select set of investors, who put money in them on a strictly private basis, he says. Because these hedge funds were shrouded in secrecy, the public at large was privy to nothing but stories of occasional mass blow-ups recounted in the popular press. As such, the connotation of hedge funds has always been more negative than anything else, and hedge funds have had about them an aura of mystery and danger that to a certain degree still persists today, and continues to put off many potential investors (and advisors, for that matter).

Furthermore, the mega hedge fund blow-ups of the past years--notably Long-Term Capital Management, Bayou and Wood River Capital Management--happened in the U.S. and not in Europe, points out Matthew Nelson, analyst in the investment management research practice at the Boston-based research firm TowerGroup, and so it is only normal that the U.S. investor base is more leery of putting its cash into ventures of this kind.

The Fund of Funds Shift Perception

That said, things have been changing in the U.S., particularly after the advent of hedge fund-of-funds (the means by which the "mass affluent" market, as Kelly calls it, can access hedge fund potential). After these structures made their appearance in the U.S. about four years ago, hedge funds started to look a little less daredevilish and easier to invest in, and financial advisors began to realize their benefits, Kelly says.

Now, the hedge fund business is on a roll, and market observers like Nelson say it is the fastest growing segment of the U.S. financial market. According to Nelson, there is about $1.2 trillion invested worldwide in hedge funds. About 80% of that amount--or $950 billion--is in the U.S., $150 billion in Europe, $75 billion in Asia (of which Japan accounts for $24 billion); and $24 billion in Latin America.

Hedge funds clearly offer better returns than the broader market, Nelson says (see sidebar below), and in an environment where spreads on most asset classes are low, there is a strong attraction for these vehicles.

"People are definitely looking at maximizing returns while taking on more risk," Nelson says. "Looking back at the 2000-2003 period, hedge funds beat the broader market indexes by about 20%, and even now, they are about 3% to 4% ahead of the broader market. We see continued growth in hedge funds over the next five years as traditional investments lose appeal and the interest in alternative portfolios grows."

According to Nelson, one of the greatest developments in the U.S. hedge fund industry has been the "retailization" of the funds. As it has become clearer to a greater number of individuals and institutions that investing in alternative structures can provide both diversity and greater returns, all manner of hedge funds have come about, from the highly leveraged, really daring multistrategy funds to the more regulated, hedge-like mutual funds. Advisors and investors can now have their pick in terms of the level of risk they want to take on, he says, and agencies like the Financial Services Authority (FSA), a regulatory body for the financial services industry in the UK, and the SEC in the U.S., are playing a greater role on the regulatory side, as evidenced by the SEC's requirement that hedge fund managers register with the Commission by February 2006.

But even if the term "hedge fund" has come to mean more than some lawless entity with a bad-boy image, these vehicles are still finding it tough to establish themselves as a durable presence in the panoply of investment options available in the U.S. Indeed, it is taking time to both educate and familiarize the U.S. advisory community with the benefits of hedge fund investing, Kelly says, and there is still a long way to go.

"It's like lighting a fire and trying to get it going," says Kelly, who spent many years working in Europe. "While U.S. investors have seen the benefits that hedge fund investing has brought to their European counterparts, things are still moving slowly, and firms like ours have to do a lot of work to educate advisors on hedge funds."

The Educational Challenge

In part, this continued challenge is reflective of the nature of U.S. advisors and investors, who in general tend to be very detail-oriented because they want to fully understand all the risks and rewards of investing in a new asset class before they go all-out and embrace the concept, Kelly says. The good news, though, is that the U.S. financial community is for the most part open to the idea of hedge fund investing, and many advisors are doing their best to understand these structures and to pass on their knowledge to their clients, he says.

"We see hedge funds as a necessity for our clients," says Ben Warwick, CIO of Denver-based Sovereign Wealth Management (and a regular Investment Advisor contributor), whose firm allocates 25% of the money it manages to alternative investments such as hedge funds and REITs. "We offer an in-house fund-of-funds that has low volatility, but if our investors are looking for a different type of return, then we go out in the market and look for it."

Even so, many have their doubts, not least because they believe that most hedge funds do not offer a credible enough risk-reward strategy to be worth the extra due diligence and the expenses that investing in them requires.

According to advisor Singh, the U.S. hedge fund industry's biggest drawback is its "market-oriented" approach. Hedge funds are only out to make themselves as appealing as possible to investors, he claims, and as such, many of them are all too quick to describe wildly attractive strategies that promise rewards beyond the imagination. However, that approach often lacks a firm foundation, Singh says; they are costly for investors to get involved in and, most importantly, they do not adequately address ways in which to protect a clients' investments on the downside.

Even though the premise of investing in a hedge fund does by its very nature mean taking on a lot of risk, there is no reason why a hedge fund cannot have a clear charter that focuses on a particular philosophy or strategy, and incorporates suitable covenants for downside protection, Singh says.

"I believe that European products are far more customer-driven than their U.S. counterparts because European clients have a certain expectation of a hedge fund," Singh says. "European clients are long-term driven, and are not always willing to take the risk that is necessary in order to achieve high returns. But European hedge funds, I believe, offer more strategy-centric and risk-addressed strategies, and this is something that the U.S. hedge fund market needs to understand."

Singh also believes that regulation is sorely lacking in the U.S. hedge fund industry, and stiffer rules and standards would make these funds more attractive to a broader range of financial managers and advisors, even if he acknowledges that being unregulated has been a blessing for hedge funds, as they have been able to follow opportunity without restrictions.

There is a general perception from financial advisors in the U.S. like Singh that hedge funds are more strictly regulated in Europe than the U.S., but really, it is not so, it is just what Europeans call "more cumbersome, because it is more a question of issues like local tax regulation, and there is a lot of legal and compliance work involved," Olson says. If a fund is registered in one country, for example, it is quite difficult for investors from another country to get into it. Regulation of hedge funds in Europe is also quite country-specific.

"The advantage of being free has not resulted in greatly enhanced returns to the investor without a cost," Singh says. "Because hedge funds are mostly unchecked, there is a tremendous potential for abuse."

A Decreasing Reward?

There is no doubt that worries over possible abuse and fraud are among the biggest concerns for anyone looking to invest in hedge funds, and for those who already use these vehicles. But many believe that this is no longer the greatest hurdle in hedge fund investing, particularly in a world where the greater appeal of these vehicles to a broader audience goes hand-in-hand with an increase in regulatory standards.

In fact, people like Mirabaud's Olson believe that the increased appeal and greater accessibility of hedge funds to a broader range of investors is actually making the hedge fund industry less attractive for players who are used to navigating these difficult waters in expectation of greater reward.

For one, the increased regulation that accompanies an asset class as it becomes more mainstream only serves to dampen creativity in the hedge fund world, as it would inhibit the truly intrepid who dare to go where others do not, Olson says. And as hedge funds have become more mainstream among different classes of investors, there has been a marked shift in their risk/reward profile, and many are no longer delivering the kinds of returns they had been in the past.

Olson--he does say that his firm invests only with pedigreed, blue-blooded hedge fund managers with proven track records of delivering consistent returns, upholding ethical principles and sticking to its advertised strategy--subscribes to the idea that true talent needs ample breathing room. Finding a way to ensure that hedge funds can continue to become more widely accepted, he says, yet not preventing managers from working their magic in order to provide stellar returns is a big challenge for the industry.

"With the enormous inflow of institutional and pension fund money, one could suspect that some hedge fund managers might tailor their risk/return profile to suit these new investors," he says. "Of course," he continues, "disappointing hedge fund results over the last few years are also probably due to the low interest-rate environment, low volatility in equity markets, and narrow credit spreads, but we are at a crossroads in terms of institutional money asking for liquidity and transparency, and this is affecting hedge fund returns."

In a world where hedge funds might be tailoring themselves to suit the demands of the market at large, there should still be space for a certain amount of creativity and unorthodoxy, Olson argues. Talented managers will always discover new ways of making money, but they should be given free rein to do so, and those who are willing to take the onus of due diligence upon themselves should also be able to seek out the newer, more specialized hedge fund managers.

The challenge for the hedge fund industry today is making sure that there is room for innovation, yet also meeting the requirements of other investors, TowerGroup's Nelson agrees.

"Let's not forget that the whole reason people get into hedge funds is because they want to take advantage of a manager's entrepreneurial freedom," he says. "The whole driver of the hedge fund industry is its innovative character, and the fact that people have the freedom to take new strides. Wrapping too many covenants around hedge funds would hold the industry back."

Still, hedge funds are here to stay, and for those who want to make out better than what the traditional markets offer, there's no other way to go. The onus now falls on advisors to sort through the risk/reward profiles of the different kinds of hedge funds that are now available, and determine what's right for their clients.

"It is still taking time to familiarize the broader market with hedge funds," Kelly says, "but we are seeing financial advisors coming to us and telling us they know that if they don't introduce hedge funds to their clients before someone else does, they will be out of the game."

Savita Iyer is a freelance journalist who has long covered different aspects of the global financial services industry. She is based in Geneva, Switzerland, and can be reached at siyerwriter@yahoo.com.

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