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

Can It Happen Here?

Wealthy individuals and institutions dominate hedge fund investing, but the mainstreaming of these products rolls on.

Strategies that traditionally have been available only in the shadowy world of privately offered hedge funds are increasingly popping up in mutual funds and exchange-traded products. A recent example is JPMorgan's June launch of the first exchange traded note that hugs a 130/30 index--a popular long/short strategy in the alternative investment space. There's also a growing list of so-called publicly registered hedge funds and managed futures funds with relatively low minimums.

Courting the man in the street with hedge funds and the like is a growth industry--literally, in some cases. Imagine that you're strolling down South LaSalle Street in Chicago, or Fifth Avenue in New York. Suddenly, you develop an urge to buy into a limited partnership focused on trading futures. You're in luck: Superfund Asset Management just happens to have walk-in shops on both streets offering managed futures investments for as little as $5,000.

Yet no one should assume that America is on the leading edge of bringing alternative investment strategies to the masses. For those who crave hedge funds in their unadulterated form--sans minimums and offering daily liquidity and a relatively high degree of transparency--it's time to look abroad.

The listed hedge fund is unknown in the United States, but the concept has a following on exchanges in Britain, Switzerland, Canada, Australia and elsewhere. The first listings date to 1996 on the London Stock Exchange (LSE) and the Swiss Stock Exchange (SSE), reports ABN Amro Bank's London office in "Alternatively," its listed-hedge fund research publication.

This is a good time to emphasize that offshore-listed hedge funds are a breed that is distinct from the handful of hedge fund management companies that trade in the U.S. Shares of Fortress Financial and Blackstone Group, for example, change hands on the New York Stock Exchange, but those are the stocks of companies that run hedge funds. The shares represent ownership in the operating businesses--not the underlying funds. Similarly, no one should confuse shares of T. Rowe Price Group, whose shares are listed on Nasdaq, with the firm's mutual funds.

The London-listed hedge funds confer ownership in the hedge fund portfolios proper. For example, purchasing Dexion Absolute Ltd., a fund of hedge funds that trades on the London Stock Exchange under the ticker DAB, is a hedge fund investment, pure and simple. Okay, but what's the practical value for U.S. wealth managers and their clients? London-listed hedge funds are off limits to U.S. investors, right? Not necessarily, and so the choices for hedge fund investments are broader than is generally known for U.S. investors.

Depending on the brokerage firm, buying shares on exchanges around the world can be fairly routine and inexpensive. Interactive Brokers, for example, offers a trading platform to U.S. investors--both individuals and professionals--that accesses 70 international stock, bond and derivatives exchanges.

Buying hedge funds on foreign exchanges may be easy, then, but is it prudent? Let's start with positives. For those who have been bitten by the hedge fund bug, the offshore choices are worth a look. One reason is that there's an extra layer of regulatory scrutiny associated with exchange trading generally. Listing shares on the London Stock Exchange and other bourses comes with basic requirements on matters of corporate governance, accounting, reporting investment results, etc. that apply to all listings there. In that sense, listed hedge funds are regulated securities. No wonder that listed hedge funds usually have Web sites offering a range of information on the portfolios including holdings, investment strategy, performance history and related data.

By comparison, U.S.-based hedge funds (excluding the mutual fund variety) are considered "lightly regulated." In exchange for the minimal oversight, hedge funds in the U.S. agree to limit investors to institutions and wealthy individuals. Yes, many U.S.-based hedge funds are registered securities via the SEC, but they still don't trade on exchanges, nor are they required to publicly report performance and other related data.

Listed hedge funds in Europe, on other hand, are available to anyone with a brokerage account, and they offer a high degree of reporting transparency. As for the choices, ABN Amro in London tracks 42 listed hedge funds, representing more than ?10 billion under management, as of May 2008. Most are funds of hedge funds, which invest in a variety of other single-manager hedge funds. The listed funds of hedge funds are of two types: internal and external. The internal variety owns a mix of the parent company's single-manager funds; the external FOFs look to managers outside the firm.

Whatever U.S. investors think of the idea, listed hedge funds are a growth industry. The rising level of assets under management is one clue. Another indication of the trend is the rising presence of listed hedge funds in stock market benchmarks. As of this past May, eight of the London-listed funds of hedge funds had sufficient size and trading liquidity to earn a spot in the FTSE U.K. All-Share index.

The basic design of listed hedge-funds is akin to a U.S. closed-end fund. As a result, market prices can and do fluctuate around net asset value, which creates an extra layer of opportunity, as well as risk in the form of discounts and premiums.

There are a number of investor-friendly features with listed hedge funds, but what's in it for the issuers? First is the ability to transfer the redemption burden to the secondary market for trading shares. That's a potentially large benefit for funds holding illiquid investments, since it allows management to minimize, if not eliminate, the potentially destabilizing task of meeting large redemption requests at awkward moments.

Marketing is another plus. Some institutional investors, including some pension funds, are prohibited from buying unlisted securities. By listing hedge funds on exchanges, managers can broaden their investor base.

Yet hedge fund managers that go the exchange route don't go all the way. According to ABN AMRO, all managers with listed funds raise the bulk of assets by means other than floating shares.

Despite the plusses, U.S.-based investors should not dive into the pool of listed hedge funds blindly--if at all. Taxes and foreign currencies are complicating factors. Another potential problem: Some listed hedge funds shun U.S. investors.

"There are a number of companies that formally state that there must not be any U.S. investors on the shareholder register," says Mark James, who follows listed hedge funds for ABN AMRO in London.

That's not an obvious obstacle, since U.S. investors can generally find a way to buy whatever they want on foreign stock exchanges. In fact, the Greenwich, Conn.-based Interactive Brokers recently confirmed for Wealth Manager that trading London-listed hedge funds was just a keystroke away for U.S. clients.

Taxes and forex, however, are not so easily resolved. "My current understanding is that U.S. investors should not invest in listed funds in taxable accounts," advises Mebane Faber, portfolio manager at Cambria Investment Management in Los Angeles. The trouble stems from what's known as passive foreign investment companies (PFICs). Given the rather harsh treatment for U.S. investors regarding PFICs, it's best to own listed hedge funds in tax-deferred accounts, such as an IRA, he says.

None of this discourages Faber, who reports that he's looking at LSE-listed hedge funds as possible investments for Cambria's high-net-worth clients. He cites the usual hedge fund charms, such as bringing diversification to a portfolio of conventional assets. Meanwhile, with listed funds "You get around a lot of the problems you otherwise have with [non-listed] hedge funds," he explains. "There are no liquidity issues, there are no lockups, and there's a lot more transparency."

That leaves the foreign exchange issue. Purchases of London-listed hedge funds necessarily clear in sterling. Unless you're interested in making a bet on the pound, buying an LSE-listed fund requires an offsetting forex hedge. Fortunately, forex hedging is easy and inexpensive with options, foreign currency ETFs and other products.

But let's not kid ourselves: Even the most rabid U.S.-based hedge fund advocates will probably never look at a foreign-listed hedge fund--much less buy one. Given the complications and risks of offshore investing even in the 21st century, perhaps it's all for the best.

That leads to the question of why there are no exchange-listed hedge funds in America. In search of answers, Wealth Manager spoke with a number of sources, ranging from a spokesman at the SEC to analysts and lawyers specializing in hedge funds. A typical response: The hedge fund industry isn't interested in publicly floating shares of its investment funds for U.S. investors.

"We as an association, and our members, don't have any interest in turning hedge funds into a retail product," says Ben Allensworth, senior legal counsel at the Managed Futures Association, a Washington, D.C. trade group representing hedge funds. "We think hedge funds work well when they're sold to sophisticated investors through private placements. That's the way the industry has developed over here, and we think that's the appropriate marketplace for it."

Presumably, the preference is partly to protect John and Jane Doe from undue risks in the marketplace. Well intentioned, perhaps, but not entirely logical. Sure, there are some aggressive hedge funds that court high risk; some even blow up. But there is no shortage of ways for retail investors to lose money in, say, levered and short ETFs, penny stocks, forex trading accounts, and even blue chip stocks that suddenly look a bit less blue.

If hedge funds are too risky for the average investor, then so too are a fair number of mutual funds and ETFs. Indeed, you don't have to look far to find some mutual funds registered under the Investment Company Act of 1940 that assume comparable, and even higher levels of risk than some of the hedge funds of funds listed in London.

No doubt some intrepid firm will one day breach industry protocol and list a hedge fund on an American exchange. Meanwhile, the lines between hedge funds and so-called conventional investment strategies have blurred to the point that real-world distinctions are often non-existent.

As for listing hedge funds in the U.S., the main criticism from the industry seems less about protecting Joe Sixpack than keeping the SEC at arm's length in regulatory matters. Restricting hedge funds to the privately offered niche helps keep regulators at bay, but how this helps the average investor is certainly not obvious.

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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