From the February 2008 issue of Wealth Manager Web • Subscribe!

February 1, 2008

Hedge Fund Lite

C'mon, admit it. You'd love to charge hedge-fund-like fees with that magical "2-and-20" formula (2 percent management fee plus 20 percent of the profits) that turns mere millionaire money managers into billionaire hedge-fund operators. The reality, of course, is that as much as you would like to charge those fees, it's never going to happen. You'll never make 2- and-20. In fact, even your "1-and-zero" fee structure is probably under some pressure. What's the solution? Some new strategies based on ETFs.

First, however, let's consider why hedge fund managers get away with so much in the first place. Why can some money managers get away with charging big fees and others can't? Obviously, performance is one factor. But there are plenty of top-notch investment advisors who achieve hedge-fund-like returns or better for clients, yet don't charge anywhere near 2--let alone 2-and-20. And there are plenty of hedge funds with lousy performance that still find individuals willing to hand over their money for the privilege of paying 2-and-20.

What's going on here?

Call it an image problem. When your clients look at you, what do they see? My guess is your clients see a trustworthy, friendly, comfortable and competent advisor. But I doubt your clients view you as an investment genius, somebody who possesses a real edge when it comes to generating excess returns. There's a reason for that: Most of us have probably gone out of our way to disclaim the notion that we are financial geniuses, that we have a crystal ball with 100 percent accuracy. After all, we don't want to base our business entirely on performance. It's better to create tight relationships via quality customer service and decent performance than shine the spotlight too brightly on performance.

Consequently, the yardstick your clients measure you by is that no-load mutual fund or exchange traded fund that they could buy on their own. Or they compare you to themselves. (And you know many think they can do just as good a job as you.) When your perceived competition only charges 25 or 50 or zero basis points, you can see why your fees are going to remain under pressure.

Hedge funds, on the other hand, are not bashful about promoting their magic potions, their black boxes, their strategies. Hedge funds sell themselves as bringing something unique to the table. They've done a masterful job of positioning themselves as the keepers of the "big secret," and the price of admission, the cost of knowing what they know, is 2-and-20.

Now, I'm not suggesting that advisors hold themselves out as investment gurus promising outsized returns. What I am saying is that fee erosion will continue unless you differentiate yourself from the advisor across the street. One way to differentiate your practice is by doing what hedge funds do--embracing the concept of strategy investing.

Look at the typical hedge fund. Many hedge-fund organizations are "multi-strategy" platforms. That is, an investor places money with a hedge fund, and those funds are spread across many different strategy teams within the hedge fund. A typical hedge fund might have a quant team, a commodities group, a long/short team, a private-equity group, a distressed debt group. One reason that strategy investing is so popular with hedge funds--aside from helping to differentiate their offerings and keeping their fees high--is that it is an enhanced form of diversification.

Strategy investing as a component of a portfolio's diversification is often lost on investment advisors. Sure, we diversify portfolios across asset classes (such as stocks, bonds, cash, real estate, art) and within asset classes (large-cap stocks, small-cap stocks, value stocks, growth stocks, international stocks). And some of us may even diversify portfolios across time. This is the 401(k) method of diversification, where clients make regular investments into portfolios over a long period of time. But I don't think many advisors give much thought to the fourth form of diversification--across strategies. One reason is that incorporating strategy investing has traditionally been difficult considering that the average account size for many advisors is probably less than $500,000.

Enter exchange traded funds.

While ETFs are often viewed as excellent vehicles for achieving diversification across and within asset groups, I think they are vastly underrated for diversifying across strategies. Indeed, there are many ETFs that provide a way for advisors to bolt on a variety of investment strategies to virtually any-sized portfolio.

For example, rare is the hedge-fund group that is long only. Most hedge funds employ short-selling strategies including "market-neutral" strategies or the increasingly popular "130/30" approach--where a fund shorts 30 percent of the portfolio and takes the short proceeds to increase the long side. A plethora of ETFs now provide easy ways for advisors to employ a variety of short-selling strategies in client portfolios. One way is simply by selling an ETF short. However, shorting ETFs may be problematic for most advisors. For starters, some of your clients may not like or understand the notion of short selling. Also, short selling requires a margin account, which may complicate the account setup process--not to mention eliminate IRAs from the mix.

Fortunately for advisors who want to sell short, ETFs exist that allow you to, in effect, go short by going long the ETF. For example, Rydex and ProShares offer a variety of "inverse" ETFs that provide returns that are opposite to a particular index or sector. The ETFs provide lots of flexibility for implementing a variety of shorting strategies.

For example, let's say you believe the move into large-cap stocks that occurred in 2007 will continue in 2008. If you want to implement a market-neutral strategy, you could buy a large-cap ETF, such as the SPDR Trust (SPY), while making a similar dollar investment in the inverse ETF of a small-cap index, such as the ProShares Short Russell 2000 (RWM). With this strategy, you are doing what hedge funds do all of the time: Employing strategies that are neutral to the overall direction of the market. Indeed, in this strategy, you don't care whether the market goes up or down. You only care that large-cap stocks outperform small-cap stocks.

And with certain ETFs, you could even effect an approach similar to the 130-30 approach that hedge funds use. Returning to our example of long large caps and short small caps, let's say you've decided to use $50,000 of a client's portfolio to bet on large caps outperforming small caps. You could take 30 percent ($15,000) and buy the ProShares Short Russell 2000 ETF. With the remaining $35,000, you could buy the Rydex 2X S&P 500 (RSU). This ETF basically leverages your investment twofold. If the S&P 500 index rises 2 percent in a day, the Rydex 2X S&P 500 should rise 4 percent. Thus, your $35,000 really buys you a $70,000 exposure to the S&P 500.

The table on page 65 lists ETFs that offer the ability to employ a variety of strategies. For example, you could use ETFs to incorporate private equity into a client's portfolio. Two notable funds include the PowerShares Listed Private Equity (PSP) and PowerShares International Listed Private Equity (PFP). You could use the Claymore/Sabrient Insider (NFO) to invest in stocks exhibiting insider buying. If you like the strategy of buying companies that are repurchasing stock, you might consider adding the PowerShares Buyback Achievers (PKW) to some portfolios. Or perhaps you believe spin-offs are undervalued. You can bolt on this strategy to a client's portfolio easily and cheaply by adding the Claymore/Clear Spin-Off (CSD). Or maybe you want to include technical analysis in the portfolio. You can do so using the PowerShares DWA Technical Leaders (PDP). You can even implement a call-writing strategy via the S&P 500 Buy/Write (PBP), which was recently introduced by PowerShares.

Another strategy tailor-made for ETFs is the contrarian approach. Two investment themes that currently cry out for some contrarian thinking are the weak dollar and international investing. Indeed, I have been in the investment business for more than a quarter of a century. And other than the tech craze of the late 1990s, I have never seen such one-sided investment thinking as I see now concerning the direction of the dollar (lower) and the overwhelming bias toward international investments.

No, I don't believe investors should eliminate all exposure to overseas investments. Still, when virtually all net inflows in the mutual fund world are going to international funds--which has been the case for the last couple of years--it smacks of the kind of rampant bullishness that coincides with tops. And try to find someone inside or outside the investment community who believes the dollar will be stronger 12 months from now! When everyone believes something so strongly, the market has a funny way of turning the tables.

If you want to add a contrarian strategy to a portfolio, and you find yourself increasingly uncomfortable with the weak dollar/international investing themes, you now have a number of ways to play this strategy via ETFs. For example, ProShares recently brought out a variety of ETFs that allow you to capture the inverse move of some foreign indices: The ProShares Short MSCI EAFE (EFZ) moves in the inverse direction of the popular Morgan Stanley Capital International EAFE Index. If that index declines 1 percent in a day, the ProShares ETF should increase 1 percent. Alternatively, if you think the performance gap between U.S. and international equities is going to narrow, you could buy the ProShares Short MSCI EAFE and buy the SPDR Trust. With this strategy, you are not so concerned about what happens to the overall market--only that U.S. stocks outperform international investments.

And if you want to take a contrarian position to the consensus opinion that the U.S. dollar will continue to weaken, you can buy the PowerShares DB US Dollar Bullish (UUP). This ETF is designed to replicate the performance of being long the dollar against the following currencies: Euro, Yen, Pound, Canadian Dollar, Swedish Krona and Swiss Franc.

Notice that none of these ETFs is your classic "index" fund in that none tracks well-known size or sector indices. For that reason, index purists often criticize these ETFs as gimmicks. I think that's not only unfair, but also misguided. Yes, these are not classic index funds. But that doesn't mean that the funds can't add value to a portfolio, especially by improving portfolio diversification by including strategies with low correlations.

The days when an advisor could simply fill up style boxes are coming to a close. Intrigued by what they are hearing about hedge funds, your clients, will demand that you offer something more than simple allocation models. And you'll need to offer more in order to differentiate yourself and to support your fee structure. ETFs offer an interesting way to incorporate strategies into portfolios, just like hedge funds. And you'll be able to do it in a cost effective--and this is important--transparent way for the client. Now that may not be enough to get you to 2-and-20, but it should go a long way toward making sure your fees don't "break the buck."

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.

Reprints Discuss this story
This is where the comments go.