Portfolio > Alternative Investments > Hedge Funds

All Hedge Funds, and Their Investors, Are Not Created Equal

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Index February 2003 QTD YTD Description
S&P 500 -1.70% -4.39% -4.39% Large-cap stocks
DJIA -2.02% -5.40% -5.40% Large-cap stocks
Nasdaq Composite 1.22% 0.12% 0.12% Large-cap tech stocks
Russell 1000 Growth -0.46% -2.88% -2.88% Large-cap growth stocks
Russell 1000 Value -2.67% -5.03% -5.03% Large-cap value stocks
Russell 2000 Growth -2.67% -5.32% -5.32% Small-cap growth stocks
Russell 2000 Value -3.36% -6.09% -6.09% Small-cap value stocks
MSCI EAFE -2.39% -6.27% -6.27% Europe, Australasia & Far East Index
Lehman Aggregate 1.38% 1.47% 1.47% U.S. Government Bonds
Lehman High Yield 1.23% 4.60% 4.60% High-yield corporate bonds
Carr CTA Index 4.79% 10.22% 10.22% Managed futures
Through February 28, 2003.

Since the early 1980s, large family offices have been in the forefront of alternative investing. This group pounced on hedge funds and managed futures years before institutions even started considering them, and today are often the first investors in fund startups. And there’s ample evidence to suggest that the super-rich have been able to maintain their wealth through their commitment to top-performing hedge funds even as their less fortunate brethren saw their portfolio values drop precipitously during the persistent bear market.

Not wanting to miss out on an investment that the ultra-high-net-worth folks have been exploiting for years, the so-called ‘mass affluent’ demographic–those with a liquid net worth of $1 million, including real estate–have become increasingly interested in hedge funds. With about 2.1 million such investors in the U.S., the potential payoff to hedge fund marketers is enormous. But the real question concerning the democratization of the alternative investment industry is whether both groups of investors–the super-rich and the mass affluent–will enjoy the same experience going forward.

There are plenty of reasons to believe that this will not be the case. For starters, the best hedge fund managers are either closed to new investments or have decided to restrict participation to super-accredited investors, i.e., those with a liquid net worth in excess of $5 million. By taking this approach, their funds are allowed to have 499 investors instead of the 99 allowed for most private placements. A further impediment is fees. Hedge funds of funds (FOFs)–investment vehicles that are designed to provide a steady, non-correlated return by investing in a portfolio of hedge funds–vary widely in both expenses and composition. Those FOFs designed for mass consumption are frequently quite expensive, typically boasting front-end sales charges and other levies that push the first-year break-even point to as high as 6%. Considering that the average fund of funds gained a scant 4% last year, these products seem poised for failure unless market conditions become more favourable.

There are plenty of reasons for advisors to avoid using hedge funds: the vehicles are hard to understand, expensive, and far less liquid than mutual funds. However, their positive attributes, which include good relative performance in the current bear market and their attractiveness to wealthy investors, have led many RIAs to include hedge funds in their asset allocation mix. Even so, advisors should realize that the hedge fund industry remains an unfair game. Access to information is not uniform, certain investors have benefits that others don’t, and portfolio transparency is sparse. If clients lack qualified eligible participant status, I’d be inclined to use real estate investment trusts, commodity funds, and hybrid mutual funds as equity substitutes.