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Fund of funds: Pay a big price for a bit of safety

Date: Wednesday, September 27, 2006
Author: Derek DeCloet, Globeandmail.com

A $10-billion (U.S.) hedge fund nearly collapses, and the story dominates the financial news for a solid week. A cloud hangs over the hedge industry. You'd think that would be an unhappy turn of events for Canada's chief hedge fund cheerleader.

Not at all, Jim McGovern says. On the contrary, he's enjoying the Amaranth Advisors saga. The only problem is the fund's meltdown hasn't created enough turmoil -- the financial markets brushed it off. "We'd like our clients to be a little bit more scared and the market to be a little bit more scared," says Mr. McGovern, chief executive officer of Arrow Hedge Partners of Toronto.

Why? Paradoxically, hedge fund scandals can be good for sales. Arrow has a nice little business in funds of funds -- taking several hedge funds, bundling them and selling them as a package. Amaranth's problems show the dangers of trusting your money to a single manager and vindicate a more diversified approach, Mr. McGovern believes. "The funds of funds are definitely going to get a better rap," he says.

Fund repackagers like Arrow are already a force. By some estimates, they account for more than one-third of the $1.2-trillion in global hedge fund assets. Mr. McGovern is probably right: The Amaranth fiasco will encourage more pension funds and other nervous investors to buy what the funds of funds are selling. But perhaps it shouldn't. Perhaps it should cause them to run in the other direction.

To understand why, you need to know why Amaranth blew up in the first place. Yes, because it stupidly bet 56 per cent of its capital on natural gas prices -- but why did it do that? The firm was once known for vanilla strategies like convertible arbitrage, which involves buying a company's convertible debt, selling its stock short as a hedge, and collecting the coupon. Yet, by this summer, Amaranth had less than 10 per cent of its assets in convertible arb, only 1 per cent in merger arbitrage and 7 per cent in buying and short-selling stocks.

All three of those are quite typical hedge fund strategies, which is the problem: As dozens of hedgies pile in, spreads get narrower and it becomes harder to make money. The Credit Suisse/Tremont index of convertible arb hedge funds fell 2.6 per cent last year; some convertible arb players, like Marin Capital, closed up shop in frustration. Amaranth, apparently motivated by a mixture of frustration and greed, decided to bet on gas prices, with disastrous results.

But we shouldn't miss one of the lessons of its failure: It is incredibly difficult to make double-digit returns right now, thanks in part to low interest rates and high price-earnings multiples. In an environment like that, high fees will really hurt you. And that's the fatal flaw of the hedge fund repackagers, because their fees range from extravagant to usurious.

To see the impact of fees, consider Arrow's Multi-Strategy Fund, a fund whose returns are based on the performance of 24 hedge fund managers. The fund's goal is to earn a return of about 8 to 10 per cent, at current interest rates. But cheap it's not. Investors pay a management fee of 2.5 per cent of assets, plus 20 per cent of any gains ("2 and 20," in hedge fund parlance).

Now do the math: Let's say you invested in the Arrow fund and watched with pleasure as those two dozen managers beat the market and got a 15-per-cent gross return. Mr. McGovern says that would be quite a feat: "Trying to sustain a 10-per-cent return is tough," he says. But after the management and performance fees take their bite, what are you left with? About 9.3 per cent. To put it another way: for every dollar the managers made, only 62 cents made it back into your pocket.

That's not to pick on Arrow; for this particular fund, at least the fees are lower than some of its competitors. Some hedge fund repackagers charge their own performance fees on top of the managers' take. "Two and 20" becomes "three and 25" or "three and 30." And the investor's share of the pie just gets smaller and smaller.

High costs can lead to absurd results. Look at the Northwater Market Neutral Trust, a fund of hedge funds. It's traded on the Toronto Stock Exchange, so the results are transparent, not to mention mediocre. The fund's net asset value rose 2.2 per cent last year. Yet, somehow, management fees and expenses totalled 7.1 per cent of assets.

Now that's scandalous.