Hedge funds go prime time

By Jeff Benjamin
February 25, 2008

Morningstar Inc.'s recent launch of a star-rating system for hedge funds is the ultimate move into the mainstream for an asset class that has long thrived as an exclusive alternative investment.

"This is just further evidence of the notion that hedge funds have a proper place in the individual investor marketplace," said Mitchell Nichter, a New York-based partner at Paul Hastings Janofsky & Walker LLP of Los Angeles.

For Morningstar, the move to apply its renowned star ratings to hedge funds represents the next step in a multiyear process to expand into the alternatives space.

"This has been in the back of our minds for a long time," said Ryan Tagal, Morningstar's director of alternative investments.

The star ratings follow nearly four years worth of data-gathering on hedge funds and coincided two weeks ago with the launch of the Morningstar 1000 Hedge Fund Index and 17 index subcategories.

The rating system for hedge funds is similar to the ratings of mutual funds and separately managed account strategies, which are ranked on a scale of one to five stars — with five being the best.

Some financial advisers welcomed the new star system as another tool for filtering through the otherwise opaque world of alternative-class investments.

"I think it might have potential, especially if it provides all kinds of other data like they provide for mutual funds," said Tom Orecchio, principal of Greenbaum and Orecchio Inc. of Old Tappan, N.J.

Mr. Orecchio, whose firm oversees $450 million in assets, also acknowledged being skeptical of any hedge fund data that is voluntarily reported to databases — as is the case with Chicago-based Morningstar's data.

"Historical performance data would always be useful in helping to determine how a fund might perform in a down market," he said. "But you have to be concerned about dirty data, incomplete data or data on funds that you might not want to invest in."

QUESTIONABLE DATA

The quality of the information in any hedge fund database is always a concern because of the voluntary nature of the performance-reporting process for the loosely regulated hedge fund industry, according to Meredith Jones, managing director with PerTrac Financial Solutions LLC of Reno, Nev.

"Hedge funds are not like mutual funds," she said. "Despite the strength of the Morningstar name, there's no excuse for not doing your homework."

Even with the brand name and long history of rating mutual funds, Morningstar is still a relative newcomer to the hedge fund space, which is something that should not be overlooked, according to Lee Schultheis, chief investment officer of Alternative Investment Partners LLC of White Plains, N.Y.

"This might be a good macro-level screening tool," he said. "But it is new and people might want to make sure Morningstar has this end of the business figured out."

Morningstar's Mr. Tagal, who has been involved in identifying and recruiting hedge funds to join the database since 2004, recognizes the need to scrutinize the data provided by hedge fund managers.

"We have an internal process that helps us to identify information that might be inaccurate," he said.

To qualify for a star rating a hedge fund must have a performance-reporting history of at least 38 consecutive months, Mr. Tagal said.

Of the 4,400 individual hedge funds in Morningstar's database, 1,800 have qualified for star ratings.

Difficult to measure, the hedge fund industry is believed to consist of more than 10,000 funds with more than $1 trillion in assets.

While there are dozens of hedge fund databases, many are used as vehicles to market proprietary in-vestment strategies.

Morningstar's database, which is the only one to apply a rating system to individual hedge funds, also includes 3,300 funds of hedge funds, which are ineligible for star ratings.

Many of the hedge funds came into the database in August 2006 through Morningstar's $10 million acquisition of Wayne, Pa.-based InvestorForce Inc.

Mr. Tagal expects the star ratings to attract wealthy individuals, financial advisers and investment platforms such as funds of hedge funds, which must subscribe to Morningstar's premium service in order to access the research.

Morningstar's database, indexes and star ratings could be relying on a market not previously targeted by hedge funds, according to Larry Eiben, chief operating officer at TFS Capital LLC, an asset manager in Richmond, Va.

"This doesn't seem to be the way big buyers of hedge funds go about researching hedge funds," he said.

Regardless, Mr. Eiben said TFS, which manages $210 million in two hedge funds and two mutual funds, reports performance to "all the databases," including Morningstar's.

"There are always a few folks who [find] us through a database," he said. "We probably spend a couple hours per month on database - reporting, and from that, we might get three prospects per year, and maybe one new client."

The star rating system for hedge funds might be new, but Mr. Tagal said Morningstar's four-year history in the database business will help persuade hedge fund managers to join the program.

"We got a lot more push-back from hedge fund managers when we first started doing this," he said.

Jeff Benjamin can be reached at jbenjamin@crain.com.