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

July 1, 2008

Hedge funds of funds-though expensive-can add significant value to client accounts.

Investing money for clients is like checking into a fancy hotel: At every turn, there's someone to tip.

All those outstretched hands add up. After fund fees, commissions, market impact costs and other levies, wealth managers are faced with the daunting challenge of adding value on top of the market return. At a time when the performance of stocks and bonds is less than stellar, adding value has never been more important.

The most obvious first wave of defense against fees is simply avoiding them. Exchange traded funds which trade like stocks and mimic a vast array of equity and fixed income indices, offer investors benchmark-like returns at rock-bottom prices. But even a fully indexed portfolio will lag the overall market, simply because advisor fees-which range from 0.50 percent to 1 percent per annum-must be taken into consideration.

Obviously, market-beating-or even market-matching-performance requires ingenuity. Advisors have a vast array of tools at their disposal, though some have questionable utility.

Leverage is one example. The newest old idea around, ETFs and mutual funds now offer advisors the opportunity to leverage client accounts as much as 300 percent. Of course, the chance of magnifying the market return on the way up comes with the chance of getting battered during a correction. Considering the risk of such an ill-timed move, magnifying the predilections of stocks is not an advisable strategy.

Utilizing actively managed mutual funds is a less draconian but more popular attempt to add value to returns. But with more funds than stocks to choose from, and with their inconsistent returns-it doesn't make sense to pay the high fees levied by active funds, when index funds are cheaper and tend to outperform even the most well-managed funds over the long run.

One intriguing tool for adding value to client portfolios is through the use of hedge funds of funds (FoFs). The private partnerships pool assets for investment in any number of hedge fund strategies in an attempt to create steady returns. But for many advisors, the fees charged by FoF managers-typically 1 percent of assets plus 10 percent of any appreciation-are too large to stomach. While it's true that such funds are expensive-especially when one considers the 2 percent management and 20 percent incentive fees charged by the underlying managers-FoFs offer investors a very useful bit of "mojo" called portfolio convexity.

Simply put, hedge funds capture a fair amount of the upside of stocks, but less of the downside. This uneven return distribution is called convexity due to the shape of returns (see The Convexity Effect table above), which magnify good periods while muting tough ones.

But what about all those fees? Surprisingly, FoFs have generated enough excess return to overcome them. This is likely due to the way information in the hedge fund industry is not uniformly distributed. Unlike the equity markets, where everyone has access to earnings reports and other data, FoF pros often know about new fund launches before anyone else and can access successful managers who are normally closed to other investors. This should keep FoFs on the radar screen of enterprising wealth managers.

Ben Warwick is Chief Investment Officer of Quantitative Equity Strategies, LLC, in Denver, Colo. and Memphis-based Sovereign Wealth Management, Inc.

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