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Ready for this? A non-hedge-fund hedge fund

Date: Monday, January 4, 2010
Author: Jeff Benjamin, InvestmentNews

New products now can give investors comparable beta at a discount to 2-and-20 fees

Regardless of the hedge fund industry's hoopla, a lot of investors are paying too much for the performance they're getting, or hope to get, from alternative strategies.

Look beyond the stellar returns of a few hedge fund managers in 2009 and you'll see that most investors received a whole lot of beta and not much alpha. It's not that the beta, or market return, is terrible, it's just that the beta is quickly and quietly becoming a commodity and is being priced accordingly.

There's no good reason for investors to pay a 2% management fee and a 20% performance fee for returns that are comparable to those now showing up in investible indexes, hedge fund replication strategies and even in a growing list of mutual funds.

Through November, hedge funds on average gained about 19%, according to Hedge Fund Research Inc., versus a 21% gain in the S&P 500.

In 2008, when the index declined by 38%, most hedge fund indexes posted declines in the 18% range.

The hedge fund industry is correct in highlighting the 2008 index returns as proof that alternative strategies can dampen volatility and limit losses. But if less volatility and lower losses are what you seek, there's no need for a hedge fund which is what more investors are starting to understand.

At least 90 registered mutual funds now offer variations on popular hedge fund strategies, according to Morningstar Inc., so while performance among registered products just as in actual hedge funds has varied, there is no mistaking the investor appetite this year.

Through November, the registered alternative funds tracked by Morningstar saw net inflows of more than $11 billion. This compares with nearly $18 billion in net outflows from all other equity mutual funds over the same period.

Most of the alternative-strategy mutual funds underperformed the S&P 500 in 2009 but offered a much smoother ride.

The Beta Hedged Strategies Fund (BETAX), managed by Lee Schultheis, gained 20.5% through November, trailing the S&P 500 by half a percentage point. But while the index was down 25.1% at the year's March 9 market low, the fund's decline was just 6.7%.

For an even smoother ride, consider the performance of such funds as the Natixis ASG Global Alternatives Fund (GAFAX) or the Goldman Sachs Absolute Return Fund (GARTX).

The Natixis Funds offering, managed by Andrew Lo, gained 10% through November and was down just 2.7% on March 9.

The Goldman Sachs Group Inc.'s product, an index fund designed to simulate the performance of a database of 4,000 hedge funds, gained 6% through November and was down 5.8% through March 9.

These two funds offer hedge-fund-like beta for total expense ratios of between 1% and 2%. And that reality is not completely lost on the broader alternatives industry.

Thanks to the tireless enthusiasm of academics and the development of products such as exchange-traded funds, we're seeing the emergence of investible indexes and replication strategies that seek to generate returns comparable to those of hedge funds.

The latest example comes from Greenwich Alternative Investments LLC, which will use 15 ETFs to mimic the performance of the Greenwich Global Hedge Fund Index.

The Greenwich index replicator fund, which is expected to be launched by March, will be marketed to institutional investors for an asset-based fee of 75 basis points. Based on the structure, there is no reason that Greenwich or some other firm couldn't roll out the same product to retail investors.

Beyond the bonus of lower fees, these hedge fund knockoffs address the liquidity and transparency issues that severely damaged the hedge fund business in 2008 when many investors could not cash out.

Of course, the index-type returns are going to work only for those happy with hedge fund beta. Those looking to make it big will have to pay for the ride as did investors in Appaloosa Management LP.

Hedge fund manager David Tepper's big bet on financial-sector stocks in early 2009 helped that fund gain more than 120% last year. That's performance worth paying for, and some investors will stick with managers and strategies for years in pursuit of such returns.

But for those with weaker constitutions or other objectives, hedge fund beta is not too shabby if you get it from the right source and at the right price.