From the September 2007 issue of Investment Advisor • Subscribe!

September 1, 2007

Getting In

How to gain access to private equity, managed futures, and hedge funds

"We think that due to the fee structure of alter-native investments, with the incentive fee and alignment of interest and so forth, some of the most talented money managers have migrated to hedge funds or private equity or real estate; so we want to get access to the smartest people in the investment universe," says John Cox, director of alternative investments at the advisory firm Charles D. Haines LLC in Birmingham, Alabama. "They also have tools available to them that you don't have in traditional money management."

Unfortunately, the most desirable alternative investment products are often inaccessible to high-net-worth investors and their advisors because of prohibitive minimum investment levels, funds closed to new investors, and onerous due diligence demands. But other means of access exist. This article will focus on the ways some RIAs gain exposure to private equity, managed futures, and hedge funds for their clients.

A previous article in Investment Advisor ("Behind the Curtain," April 2007) explored the reasons RIAs use alternative investments. A subsequent article will examine risk factors in these investments and precautions necessary to protect investors.

Private Equity: Funds of Funds

The stellar returns of the past five years are the chief attraction of private equity investments, says Rick Rickertsen, managing partner at Pine Creek Partners, a private equity firm based in Washington, D.C. These investments not only "juice" the portfolio, but also provide important diversification. However, steep minimum investments, in the $5 million to $10 million range, make investments in individual funds prohibitive for all but the wealthiest individuals.

At Charles D. Haines, clients for whom private equity is appropriate have a 6% to 10% allocation, says Cox. Because of the difficulty of getting significant diversification and access to top-tier managers, the firm works exclusively with two funds of funds. One is Park Street Capital in Boston, whose seven principals have been making private equity investments for more than 10 years.

Fort Washington Capital Partners Group in Cincinnati has operated a fund-of-funds program since 1999. It currently manages five national funds of funds, as well as a series of regional ones and a co-invest fund. The firm is the private equity arm of Fort Washington Equity Advisors, an RIA that runs $30 billion for its parent, The Western-Southern Life Insurance Co., and for third-party clients.

FW Capital caters to pensions, foundations, endowments, and some high-net-worth investors, the majority being retired entrepreneurs with assets in the $50 million to $100 million range. It requires a minimum investment of $3 million.

According to managing director Steven Baker, FW Capital invests in best-of-breed venture capital and buyout funds; approximately 80% of its capital is invested domestically, with 20% invested elsewhere. The firm also offers a separate program for individual clients.

Diversification is a key advantage of using funds of funds to gain exposure to private equity (for more on diversification in private equity, see sidebar below). With an FW Capital product, says Baker, investors get access to 15 to 25 venture, buyout, and special situation limited partnership vehicles.

The Due Diligence Issue

Amid so much diversity, finding the best managers in each category puts a very heavy burden on due diligence. Top-tier funds of funds are well equipped to handle this. "The difference between an average venture capital or buyout manager and a top-quartile venture capital or buyout manager is immense--many, many basis points," says Baker. "Because private equity investments are 10- to 15-year partnerships," he points out, "a lot of homework upfront is crucial--on the reputation of the firm, its track record, and its standing in the community in terms of what the banks think of it if it's a buyout shop or what entrepreneurs think of it if it's a venture capital fund."

FW Capital for the most part does not invest in the first of a series of funds, says Baker. "We typically try to steer our capital to well-established firms that have been doing this for a long time, and have very solid organizational structures and processes."

Another huge advantage of a fund of funds is operational simplicity. Even for an investor wealthy enough to be able to invest in a diversified assortment of 15 to 25 funds, allocating to these vehicles involves much complexity. Baker points out that private equity funds are just-in-time vehicles: An investor makes a capital commitment, then funds capital calls on those commitments. Commitments to 15 to 25 funds means funding each of them four or five times a year; operational complexity mounts. Each fund provides a quarterly report, and each provides a Schedule K-1; the timely receipt of these will determine whether the investor will be able to meet certain tax-filing deadlines.

"With a fund of funds, you basically do three or four capital calls a year for the investment period, you get one K-1, and you get one report," says Baker. "That's pretty compelling for people who are busy and who have other things they would like to be doing with their time."

Finally, high-net-worth clients want customer service, something large institutional private equity shops aren't suited to provide, says Baker. "They're used to seeing their institutional and limited partners at annual meetings, and they talk to them periodically on the phone, but it's a very businesslike relationship. High-net-worths sometimes want to understand more about what's going on in the portfolio or more about the life cycle and details of the investments."

Managed Futures: How Much to Allocate

Charles D. Haines has been investing in managed futures since 2001. This strategy, to which the firm allocates 5% to 7% of client assets, is "one of the most powerful asset classes in terms of the correlation benefits; sometimes it's even negatively correlated for long periods," says Cox.

David Reilly, director of portfolio strategies at Rydex Investments, agrees. "If you look at managed futures as an industry or an asset class or set of strategies, they offer attractive investment characteristics, i.e., historically positive return over time and very low volatility relative to equities; from a characteristic standpoint, it appears to be very useful and very desirable from a portfolio construction, asset allocation standpoint."

Charles D. Haines prefers a multimanager approach to managed futures, says Cox, because underlying commodity trading advisors, or CTAs, can be very volatile and can have significant drawdowns just by the nature of the strategy. He says the firm has identified a group that has put together a pooled entity of seven or eight trading advisors, which might not otherwise be accessible. The underlying CTAs include two eminent London-based firms, Winton Capital and Aspect Diversified.

Wealth advisory firm Lenox Advisors, which has a small allocation to the commodities sector, prefers the fund route, says Bradley Snyder, senior vice president of Lenox Advisors' asset management group in the firm's Chicago office. "We tend to have a fairly small allocation to commodities because you're potentially going to get commodity exposure in other types of investments you have. We prefer not to make a bet on the direction of the commodity markets, but leave that to, say, hedge fund managers. For smaller clients, we may look at something like the PIMCO Commodity Fund just to get a little exposure there--an uncorrelated asset class."

The year 2007 has seen several U.S. firms offer innovative ways to access managed futures. Later in the year, New York-based Asset Alliance Corp, which takes equity stakes in alternative investment firms, will roll out a mutual-fund-like product called BTOP50 Managed Futures Fund. Its $10,000 minimum investment, convenient tax reporting, and monthly redemptions will make it an attractive investment for retail investors. The hybrid fund will strive to replicate the Barclay BTOP50 index, which reflects the net performance of some two dozen large trading advisors.

In March 2007, Rydex Investments launched the Rydex Managed Futures Fund, the only open-end managed futures product on the market at present, according to Reilly. It has a minimum investment of $2,500, daily liquidity, and a 1.65% expense ratio.

"As with hedge funds, which can be categorized similarly, the structural problems associated with accessing managed futures have really kept them off limits for retail investors," says Reilly. "You join a commodity trading pool, open up a managed futures account, which most retail investors aren't going to do, and it comes with many of the same impediments hedge funds have: high minimums, accredited investor rules, lockup provisions, and the presence of performance fees, which put the overall fee structure way, way up there."

Rydex, in contrast, takes these managed futures and hedge fund strategies and offers them in an open-end mutual fund format. "That marries the benefits of open-end registered products with the benefits of the investment strategy from a risk and return standpoint," says Reilly. "The minimums come down to regular mutual fund minimums; you have transparency because they're open-end mutual funds; you have daily liquidity; no lockup provisions beyond the standard 30-day redemption penalty; the cost structure comes way, way down; and you've got daily NAV and daily liquidity."

But he emphasizes that the new managed futures fund is not a fund of funds. Rather, Rydex has taken a preexisting index, the Standard & Poor's Diversified Trends Indicator, which captures the characteristics of the managed futures industry, and created a mutual fund that delivers the day-to-day price characteristics of that index by investing in structured notes; these are linked on a price basis to the daily performance of the index--index-linked notes. (See sidebar for a deeper explanation of how the fund operates.)

From its launch date on March 1 through July 25, the fund was up 0.2%. It opened at $25/share, hit a high of $25.56 on June 18, and traded off to its current $25.05.

Reilly says the fund has proven popular, having amassed assets of $155 million through July. It has been especially successful with distribution houses that are starting to pay attention to alternatives because they're getting questions from their advisors about alternatives, he says.

Hedge Funds: Multimanager, Multistrategy

Investors put hedge funds in their portfolios to gain absolute returns. They want managers who will protect their downside while allowing them to receive returns that are still correlated to the asset class. Funds of funds have been called "training wheels" for initial investors in hedge funds; these contain different kinds of hedge funds in order to diversify business risk specific to each manager. A diversified fund of funds will also expose investors to risk factors uncorrelated to the movement of stocks and bonds.

Certainly, for many investors, including institutions and high-net-worth individuals and their investment advisors, multimanager, multistrategy funds are the route of choice to hedge fund investment.

"Funds of funds is going to be our preferred way of doing this, simply because when you look at the universe of hedge funds--there are currently some 8,000 hedge funds available--we're sensitive to situations like Amaranth and what recently happened to Bear Stearns," says Lenox Advisors' Snyder. "We want to make sure we're not exposing our clients to too much risk, and certainly a fund of funds is a great way for us to get the diversity."

Lenox Advisors, which serves primarily Wall Street executives, including hedge fund managers, business owners, and attorneys, uses different platforms to source its funds of funds, says Snyder. All told, Lenox has access to some 30 fund-of-funds shops, including Tremont, Lazard, Man Investments, the Optima Group, Taylor, and several other larger groups. This narrows its work, allowing it to look at each one of those individually, and determine what will make sense for a particular client. Analysts based in Lenox's New York office conduct due diligence on these groups.

At Charles D. Haines, where hedge funds are its biggest alternatives allocation, the firm created an entity to pool client money that then makes allocations to managers that have higher minimum investments, a combination of funds of funds and individual managers, says Cox. These "Haines" funds give the firm economies of scale and allow its clients who might not have a significant allocation to hedge funds the ability to get diversification by going through that vehicle. Clients are charged a fee based on the amount of assets they have with the firm; they do not pay an extra charge for alternative investments. (The firm does not use this structure for private equity and for managed futures or any other alternative investments.)

In-house due diligence on the funds is done primarily by Cox and Charlie Haines, the firm's founder and chief executive. But they supplement this activity by sharing information with contacts in a study group of RIAs Haines helped found 10 years ago (see sidebar).

Hedge fund allocations, 25% to 40% of the alternative component of clients' portfolios, are about equally divided between funds of funds and individual managers. The firm works with Chattanooga-based Pointer Management, which has been making hedge fund allocations for some 15 years; its fund of funds has $1.3 billion under management. It also allocates to Third Avenue Special Situations Fund, which invests in distressed situations or overlooked opportunities; this fund currently has about $125 million under management.


Michael S. Fischer is a writer in New York who focuses on the financial services industry. He can be reached at msf7@columbia.edu.

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