Hedge Fund Copycats Catch Mutual Fund Buyers as Returns Dwindle

Date: Monday, February 26, 2007
Author: Danielle Kost and David Clarke, Bloomberg

 Feb. 26 (Bloomberg) -- Just when mutual funds are about to peddle the closest thing to hedge funds to individuals, the returns of these exclusive investments for millionaires are drying up.

Hedge funds have risen at an average annual rate of 8.4 percent since 2000, less than half the gains of the 1990s, according to data compiled by Chicago-based Hedge Fund Research Inc. Vanguard Group's flagship mutual fund tracking the Standard & Poor's 500 Index climbed 15.6 percent last year, compared with the 6 percent drop of Goldman Sachs Group Inc.'s biggest hedge fund, whose management fees are about 10 times steeper.

The subpar performance isn't stopping the world's largest financial institutions, including UBS AG in Zurich and JPMorgan Chase & Co. in New York, from chasing higher fees by offering copycat hedge funds to people with as little as $1,000 to invest. Assets of the so-called long-short funds almost doubled to $16.5 billion in the U.S. in the past two years, according to Financial Research Corp. of Boston, which tracks money flows.

``A lot of people buying these funds don't know what they're getting into,'' said Ross Levin, 47, president of Accredited Investors Inc., an Edina, Minnesota-based financial advisory firm that oversees $650 million.

Long-short funds bet on falling as well as rising stocks, a strategy most mutual funds are prevented from pursuing. They gained an average 7.2 percent in 2006, trailing the S&P 500's 15.8 percent advance including reinvested dividends, Chicago- based Morningstar Inc. reported. Their record didn't dissuade investors from plowing $4.9 billion into the funds last year, almost triple 2005's deposits.

Goldman's Goldmine

Fund executives like long-short funds because they carry average fees of 2.2 percent. That's almost 50 percent more than standard stock funds, whose $6 trillion in assets generate about $90 billion in annual fees for money-management firms.

Vanguard Group of Valley Forge, Pennsylvania, the second- largest U.S. mutual-fund company after Fidelity Investments, levies a 0.2 percent fee on its $120 billion S&P 500 index fund, producing about $240 million of fees. New York-based Goldman, Wall Street's most profitable firm, earned about $700 million in management and performance fees from its $10 billion Global Alpha fund in the year ended Nov. 24.

``The fees are higher than most mutual funds,'' said Todd Trubey, a Morningstar analyst, referring to long-short funds. ``You have some hope that they'll trend down over time, but given that these products are likely to be seen as competitors to hedge funds, I don't know if that's going to happen.''

The Short Premium

UBS, the world's biggest money manager with $2.4 trillion of assets, and Mellon Financial Corp. of Pittsburgh opened their first long-short funds to individual investors last year. JPMorgan added one fund, bringing its line-up to five. The firms don't say how much revenue they earn from the funds.

While long-short managers typically focus on equities, their hedge-fund counterparts invest in everything from currencies and commodities to airplane leases and hurricane insurance. Hedge funds attracted a record $126.5 billion last year, increasing the industry's assets to more than $1.4 trillion, according to Hedge Fund Research. Long-short hedge funds had $409 billion in assets, the most of any category.

The ability to sell stocks short is the main difference between long-short funds and standard mutual funds such as the $162 billion Growth Fund of America and the $70 billion Fidelity Contrafund. In a short sale, an investor borrows shares from a broker and sells them on the open market. It's a bet the stock will decline and the broker can be repaid at a lower price, with the investor pocketing the difference.

Unfair Comparisons

Shorting also is used as a hedge against a falling stock market, which was the original purpose of hedge funds, and which is why they tend to outperform benchmark indexes in bear markets. When the S&P 500 fell 23 percent in 2002, the average hedge fund was off 1.5 percent. Proponents of long-short funds say comparing returns with those of stock funds or market indexes aren't meaningful.

``These investments are intended not to necessarily beat the S&P and the Dow Jones Industrial Average,'' said David Prokupek, 45, chief executive officer of Denver-based Geronimo Financial LLC. The firm oversees $450 million in absolute-return strategies, which seek to generate profits regardless of whether markets rise or fall.

``They're actually more intended to do better when those indexes aren't doing as well,'' he said.

`Absolute Rubbish'

Protection against market declines was why Graeme Currie, a 48-year-old financial adviser in the suburbs of Edinburgh, bought shares of the Matrix Bastion Fund. The fund, which invests in a basket of hedge funds, returned 7.6 percent last year. Its fees are eight times those of the Vanguard 500 Index Fund, which topped Matrix Bastion's performance by 8 percentage points.

``Most of these funds have been absolute rubbish,'' Currie said.

Long-short funds also can invest in futures and options and use leverage to increase returns, though not to the same degree as hedge funds, said Morningstar's Trubey.

There are 51 U.S. long-short funds, with 37 introduced since 2000, according to Morningstar. The growth comes as the hedge- fund industry encounters increased scrutiny from regulators and politicians. The U.S. Securities and Exchange Commission has proposed raising the minimum investment to $2.5 million for hedge-fund buyers, up from $1 million.

The collapse of Greenwich, Connecticut-based Amaranth Advisors LLC last September raised concern that investors and lenders were exposed to hidden risks because hedge funds disclose little about their investments or borrowing. Amaranth, run by Nicholas Maounis, lost $6.6 billion in less than a month, the most ever by a hedge fund.

Market Discipline

A U.S. presidential panel last week said the current system of hedge-fund regulation is ``working well'' and market discipline remains the best way to protect investors and the financial system. Its view conflicts with positions adopted by some European governments, led by Germany, and some U.S. state officials, who say more regulation is needed.

``This turns up the heat on pension-plan managers and mutual-fund managers to make sure investments are appropriate,'' said Jay Baris, an attorney at Kramer Levin Naftalis & Frankel in New York who represents hedge funds. Unlike hedge funds, long- short portfolios are required to disclose their holdings and performance, and they are regulated by the SEC.

Institution Envy

Mellon's Global Alpha Fund, which relies on computer models to choose investments, has gathered $237 million since it was started in May. The fund, modeled after a similar product for institutions, has returned 11 percent. The institutional fund's assets have quadrupled to $32.9 billion since the first quarter of 2003.

``There's been a lot of interest among individual investors about what institutions are doing,'' said Jon Baum, 46, vice chairman of distribution at Pittsburgh-based Mellon.

UBS's U.S. Equity Alpha Fund, managed by a 42-person team, has attracted $150 million and climbed 9.5 percent since it opened Sept. 26. JPMorgan's biggest long-short fund, the $2.1 billion Multi-Cap Market Neutral Fund, managed by Bala Iyer, has returned 5.2 percent a year on average since 2004.

Long-short funds have been sold in Europe since 2004, when the European Union introduced rules allowing mutual funds to follow some of the strategies used by hedge funds. Nine absolute- return funds were started in the U.K. in 2006, up from four in 2004.

`Plenty of Room'

BlackRock Inc.'s Absolute Alpha Fund, managed by Mark Lyttleton in London, opened two years ago. New York-based BlackRock has raised $200 million for the fund and charges a management fee of 1.75 percent. The average actively managed stock mutual fund sold in the U.K. charges about 1.45 percent, according to London-based research firm Lipper Fitzrovia.

Scottish Widows Investment Partnership, based in Edinburgh, started three funds about four months ago that can take long- short positions, one for U.K. stocks, one for U.K. bonds and a so-called macro fund that bets on global economic trends.

UBS recently started offering long-short strategies focused on Europe and Asia for its institutional clients. The company is considering offering mutual funds with similar scopes to individuals, said Scott Bondurant, 47, the company's global head of equity long-short investments in New York.

``There's still plenty of room for growth,'' he said.

To contact the reporters on this story: Danielle Kost in Boston at dkost1@bloomberg.net ; David Clarke in Edinburgh at dclarke3@bloomberg.net