Hedge funds for the masses

Date: Friday, October 27, 2006
Author: Jonathan Chevreau, Financial Post

What's good for institutions may not benefit public.

In its campaign to take hedge funds to the common man, the industry often invokes the fact that well-known pension funds use their product to diversify risks. In this context, a global evaluation of hedge fund-of-fund use by institutional investors released by Mercer Investment Consulting is of interest.

The vast majority of those investors are pension funds, but they also include foundations and endowments, charitable organizations, insurance companies and government funds.

It will be fascinating to see whether rising institutional use of hedge funds will stimulate more use by retail investors. Arguably a similar phenomenon occurred with passive low-cost "indexing" strategies. Of course, index funds and hedge funds are almost polar opposites, since hedge funds are like hyperactive managed funds with high fees to match.

The fund of hedge funds (FoHF) structure happens to be the one most suited to retail investors, since they use multiple managers and strategies, albeit with fees piled on top of fees. In Canada, principal protected notes (PPNs) linked to FoHFs are available to virtually any investor, since they get around the accredited investor minimums imposed on pure hedge funds. As we have seen in the case of Portus and other linked notes, the results have not always been positive for investors.

There's little doubt institutional investors are already using hedge funds or plan to soon. Mercer polled 181 institutional users around the world and found 33% already use FoHFs. Another 19% intend to do so in the next two years.

Mercer expects FoHFs won't peak for several years, since current users will increase their allocations while late adopters continue to jump aboard. Many institutions appear to be merely wetting their feet with this asset class: the median allocation was just 5% (i.e. half the sample had less than 5% and half more). However, the median allocation is expected to rise to 7.8% within two years. As Mercer comments, "allocations of 5% to 10% are usually necessary to make a meaningful difference in portfolio risk profiles."

The two main reasons cited for using them was risk reduction and enhancing returns: the firms surveyed expect returns will range from 4% to 6% (net of fees) over the risk-free return of cash or treasury bills. The median expectation was 5% but "return expectations have declined over the past several years."

The report cites one consultant's observation that "I often see FoHF with unrealistic return expectations."

The biggest role cited, in 85% of cases, was the perception that FoHFs can have positive returns in all market conditions. The latter is the oft-claimed "absolute return" claim of hedge fund marketers. Of course, treasury bills also provide "absolute" returns but that's not usually appended to the claim.

Fees are also an issue: 35% are dissatisfied with fees, which are typically a 1% management fee plus 5% to 10% performance fees. But that's a better deal than the "two and 20" that's become common at the retail level. Institutional users can also negotiate lower fees.

Of 28 Canadian users polled, 21% currently use FoHFs and 18% intend to try them in the next two years. Americans are bigger users: Of the 38 firms contacted by Mercer, 42% of the U.S. institutions currently use FoHFs and 16% plan to do so.

Among non-adopters, concerns include lack of liquidity, high fees, too much leverage and lack of transparency.

Hedge fund marketers often point to the Yale University Endowment Fund's use of hedge funds as a sort of reference sell for retail investors. However, Yale chief investment officer David Swensen has argued in his book, Unconventional Success, that it does not follow that institutional use of hedge funds means small investors should follow suit.

Hedge funds constitute an entire chapter of Canada Steps Up, the final report of the Task Force to Modernize Securities Legislation in Canada. Released earlier this month, the report says 90% of the money held in Canadian funds of hedge funds are invested in underlying U.S.-based hedge funds. The report criticized the "backdoor" availability of hedge funds linked to principal-protected notes, and recommended that the underlying investment should be regulated. It also suggested a framework be established "to allow hedge funds to be widely sold to the public."

Note the word "sold" -- as in "mutual funds are sold, not bought."

jchevreau@nationalpost.com