Transatlantic Teachers

Like most European financiers, Johan Olson, investor relations manager at private bank Mirabaud & Cie in Geneva, Switzerland, doesn’t bat an eyelid at the mention of hedge funds.

“We have used hedge funds-of-funds as a tool to diversify and decorrelate traditional bond and equity portfolios for 30 years,” Olson states, coolly. “We have a track record of doing this, and our bank would not have 25% of its clients’ money in hedge funds if this strategy did not work.”

Call it blas?(C), but this approach is not at all unusual in Europe’s financial community, where hedge funds have long been a part of the portfolios of high-net-worth individuals. For decades now, European advisors have been recommending and investing in all manner of hedge funds for diversification and portfolio enhancement, and using these vehicles has become part and parcel of mainstream investing.

In the United States, by contrast, most financial advisors, brokers, and investors are still wont to think of hedge funds as complex, dangerous, and volatile instruments that are hard to figure out. Even if they acknowledge the great potential hedge fund investing has to offer, many financial advisors in the U.S. just do not have the same comfort level vis-? -vis hedge funds enjoyed by their European counterparts. Indeed, advisors like Hemant “HP” Singh, chairman of the New York-based firm Private Wealth Management believe hedge funds are more pain than pleasure, and as such, would rather not get involved with them at all.

“The term ‘hedge fund’ in its origin meant a fund that is capable of hedging risk and reward in order to successfully manage and take advantage of the volatility of the market,” Singh says. “I do not consider hedge funds for our clients because I do not believe that they have served that purpose. They can be difficult to understand and expensive, and are usually involved with seemingly sound but very complex strategies that I have found to be not worth the expense nor the risk for my clients.”

So, then, what’s the origin of Europeans’ confidence in hedge funds?

Just Another Asset Class?

Some say that comfort level arises from the way in which the Europeans view hedge funds. Rather than thinking of them as a category of investments unto themselves, a rare breed of investing vehicle to be approached only with the utmost caution, the European financial community has instead considered hedge funds an asset class like any other, looking upon them as just another means to diversify and enhance a portfolio of investments.

“We don’t look at hedge funds as a separate asset class, but rather, as just different strategies of managing bonds and equities,” Olson says. “This has allowed us to include [hedge funds] in our asset allocation models, all the while managing money on a discretionary basis with the objective of preserving capital.”

While some might think that this approach is reflective of an investor base that is far more sophisticated than its U.S. counterpart, the dichotomy is not so simple, and one needs to probe deeper to see that the prevailing attitudes are a result of the historical and structural differences between Europe and the U.S. Although the United States is the largest hedge fund market in the world, there are several factors at play that have held back the more widespread acceptance of hedge funds as viable instruments for portfolio diversification, says John Kelly, president and CEO of Man Investments USA, and these continue to play a role in determining the level of acceptance of hedge funds.

While in Europe the use of hedge funds to enhance portfolios of individual clients has been a common practice for players from large banks to smaller, boutique firms, hedge funds in the U.S. were always the domain of truly wealthy investors, Kelly says. They were reserved only for a class of uber-rich individuals with gargantuan fortunes, who were as financially sophisticated as their high-end advisors, and fully understood both the complexities and the benefits of investing in hedge funds. Therefore, hedge funds were offered exclusively to this select set of investors, who put money in them on a strictly private basis, he says. Because these hedge funds were shrouded in secrecy, the public at large was privy to nothing but stories of occasional mass blow-ups recounted in the popular press. As such, the connotation of hedge funds has always been more negative than anything else, and hedge funds have had about them an aura of mystery and danger that to a certain degree still persists today, and continues to put off many potential investors (and advisors, for that matter).

Furthermore, the mega hedge fund blow-ups of the past years–notably Long-Term Capital Management, Bayou and Wood River Capital Management–happened in the U.S. and not in Europe, points out Matthew Nelson, analyst in the investment management research practice at the Boston-based research firm TowerGroup, and so it is only normal that the U.S. investor base is more leery of putting its cash into ventures of this kind.

The Fund of Funds Shift Perception

That said, things have been changing in the U.S., particularly after the advent of hedge fund-of-funds (the means by which the “mass affluent” market, as Kelly calls it, can access hedge fund potential). After these structures made their appearance in the U.S. about four years ago, hedge funds started to look a little less daredevilish and easier to invest in, and financial advisors began to realize their benefits, Kelly says.

Now, the hedge fund business is on a roll, and market observers like Nelson say it is the fastest growing segment of the U.S. financial market. According to Nelson, there is about $1.2 trillion invested worldwide in hedge funds. About 80% of that amount–or $950 billion–is in the U.S., $150 billion in Europe, $75 billion in Asia (of which Japan accounts for $24 billion); and $24 billion in Latin America.

Hedge funds clearly offer better returns than the broader market, Nelson says (see sidebar below), and in an environment where spreads on most asset classes are low, there is a strong attraction for these vehicles.

“People are definitely looking at maximizing returns while taking on more risk,” Nelson says. “Looking back at the 2000-2003 period, hedge funds beat the broader market indexes by about 20%, and even now, they are about 3% to 4% ahead of the broader market. We see continued growth in hedge funds over the next five years as traditional investments lose appeal and the interest in alternative portfolios grows.”

According to Nelson, one of the greatest developments in the U.S. hedge fund industry has been the “retailization” of the funds. As it has become clearer to a greater number of individuals and institutions that investing in alternative structures can provide both diversity and greater returns, all manner of hedge funds have come about, from the highly leveraged, really daring multistrategy funds to the more regulated, hedge-like mutual funds. Advisors and investors can now have their pick in terms of the level of risk they want to take on, he says, and agencies like the Financial Services Authority (FSA), a regulatory body for the financial services industry in the UK, and the SEC in the U.S., are playing a greater role on the regulatory side, as evidenced by the SEC’s requirement that hedge fund managers register with the Commission by February 2006.

But even if the term “hedge fund” has come to mean more than some lawless entity with a bad-boy image, these vehicles are still finding it tough to establish themselves as a durable presence in the panoply of investment options available in the U.S. Indeed, it is taking time to both educate and familiarize the U.S. advisory community with the benefits of hedge fund investing, Kelly says, and there is still a long way to go.

“It’s like lighting a fire and trying to get it going,” says Kelly, who spent many years working in Europe. “While U.S. investors have seen the benefits that hedge fund investing has brought to their European counterparts, things are still moving slowly, and firms like ours have to do a lot of work to educate advisors on hedge funds.”

The Educational Challenge

In part, this continued challenge is reflective of the nature of U.S. advisors and investors, who in general tend to be very detail-oriented because they want to fully understand all the risks and rewards of investing in a new asset class before they go all-out and embrace the concept, Kelly says. The good news, though, is that the U.S. financial community is for the most part open to the idea of hedge fund investing, and many advisors are doing their best to understand these structures and to pass on their knowledge to their clients, he says.