How Objectivity and Credibility Are Lost

When the private placement tax shelter market imploded in the early 1980s, these planners lost more than assets and revenue. They also lost credibility with their best clients as objective financial advisors. In some cases, it took years to repair the damage.

Now, it's 20-25 years later and here comes another secret investment with zip and status. It's even packaged as a private placement limited partnership. Of course, I'm talking about hedge funds.

If you're offering hedge funds to your clients, or thinking about it, I'd like to give you eight reasons why you may want to pause and rethink. These reasons won't convince you to stop offering your clients alternative asset classes, talented managers outside the mainstream, or low volatility strategies-all of which are hedge fund benefits. I hope to convince you that better ways to achieve these benefits are available, or on the way.

#1: A Flood of Money and Mediocrity

Hedge funds are hot, no question about it-in part because it has become widely accepted that hedge funds offer growth potential with lower risk than stocks and equity mutual funds. According to Van Hedge Fund Advisors, there are now about 4,400 U.S. hedge funds in operation, holding $315 billion in assets. That's a lot of capital when you consider that three-fourths of the market consists of individuals. (The rest is institutional.) It's perhaps 8-10 times the money U.S. hedge funds held five years ago.

A major difference between then and now is the quality of managers. When hedge fund money was scarce, managers needed top credentials and stellar track records to survive. But as money keeps pouring in, hundreds of ordinary portfolio managers, traders, analysts and brokers are hanging out a hedge fund shingle. Fundamental analysts who have spent careers hunched over balance sheets are touting market-neutral trading strategies with 1200% turnover. As industry news source FundFire recently observed: "The influx of mediocre managers into the industry makes the search for good managers even harder."

#2: Misleading Risk Statistics

Many hedge funds claim they control risk better than actively managed equity mutual funds. They support these claims with graphs comparing historical returns to risk, measured by standard deviation. They cite reputable industry sources, such as CSFB Tremont or Hedge Fund Research (HFR).

But there are three big problems with this analysis. First, standard deviation only measures one aspect of risk, short-term volatility. Second, hedge fund indexes focus mainly on large established funds, not the whole industry. For example, fewer than 400 funds meet CSFB Tremont's criteria for index inclusion. The vast majority of small funds, including those that have failed and gone out of business, aren't measured. Third, hedge funds go out of business at a high rate. A study by author Stefano Lavinio, published in The Hedge Fund Handbook, found that 66% of hedge funds went out of business within ten years. That means the most important risk to evaluate in hedge funds is fundamental business risk, not short-term volatility.

#3: Costs May Be Higher Than You Think

A standard fee structure in hedge funds is "one and twenty"-a 1% asset-based fee plus 20% of performance (above a high water mark) as manager incentive. That's costly to begin with, but investors face other expenses. For example, trading costs usually are not included in these fees, and they can be high, in part because hedge funds like to direct commissions to brokerage firms that feed them research, and the cheapest brokers don't always have the best research. Typically, the cost of organizing the fund is charged back to investors on an amortized basis over the first few years, which penalizes those who invest first. Administration and auditing can add another 1%. When you read a typical hedge fund Private Placement Memorandum (PPM), you realize that an unscrupulous general partner has an unlimited travel and entertainment expense account, courtesy of limited partners.

Of course, there are ethical hedge fund operators who work hard to hold down costs, because it enhances performance and returns. But how can you verify this until a fund has been in business several years, and unless you've studied its audited statements and K-1 tax returns?

#4: Tax Inefficiency

Most hedge funds couldn't care less about your clients' tax needs. If the K-1 shows less than 80% short-term gains, the client's lucky. The tax-smart way to invest in hedge funds is through retirement plans and rollovers. But most hedge funds discourage plan investments because they don't want to be subject to ERISA rules. They also don't want to be bothered with liquidity-related events like plan loans, hardship withdrawals and minimum distributions. /p>

#5: Operational Weakness

Operationally, a hedge fund is a mutual fund in microcosm. The investor's experience depends on the hedge fund's performance not just in asset management, research, and trading but also in clearing and reporting, communication, marketing, compliance, systems, internal accounting and personnel. Yet many operators moving into hedge funds today have little or no business-building experience or plans. To make a hedge fund group cost-effective takes a minimum of $100 million under management, and this can be spread across several funds in a "master-feeder" structure. But many new hedge funds are destined to bump along with $50 million or less. Their infrastructure will never be built, and their investors will suffer. (Before investing a client's money, ask the hedge fund whether its own employees have a company retirement plan.)

#6: Lack of Disclosure, Transparency and Liquidity

If you believe your role is to help clients monitor manager performance, you'll be sitting on the bench with most hedge funds. Even if they release a quarterly or monthly performance summary, it's rarely audited, and you incur risk in relying on it. The most important data for monitoring hedge fund risk, amount of leverage employed, is rarely disclosed. At year-end, you can try to align the audited statement and K-1 return data (the limited partner's capital account) with published performance data, but the hedge fund may not help you. If the hedge fund has several bad months in a row, you may find information even harder to come by. Although hedge funds usually allow redemptions after a blackout period (with notice), they don't like them. If you insist on redeeming funds for one client, you may not be welcome to invest for others. In the worst case, in which a hedge fund suffers heavy losses or decides to liquidate, you may find that normal redemption procedures no longer apply, because the general partner has the right to modify them if necessary.

#7: Undefined Roles and Lack of Compensation for Advisors

Unlike mutual funds and separate accounts, which treat professional advisors as partners in their process and compensation structure, the hedge fund industry has not yet developed a rewarding role for advisors. Traditionally, hedge funds have paid for distribution by directing commissions back through registered reps, but that's a cumbersome process for most advisors and independent broker-dealers. If your client is intrigued by a hedge fund, you are the best person to assist in its evaluation. If the client insists on investing, you should continue to monitor the investment. If its fees are high, you can (and should) try to negotiate them down. If you are an RIA, you might ask the client to pay you the negotiated savings through a retainer fee. That's a smart way for an advisor to stay involved in a client's decision to participate in hedge funds, without conflict-of-interest or out-of-pocket cost to investors. However, in pursuing it, you're not likely to get the support of most hedge funds.

#8: Regulation and Better Choices Are Coming

The SEC and other regulators are reining in the "unregulated" aspects of the hedge fund industry. This has caused some large financial institutions, including mutual fund groups, to temporarily put hedge fund development projects on hold, until the smoke clears. When it does, you'll probably see a trend in which mutual funds and separate accounts begin to offer more alternative styles that have worked well in hedge funds, including long/short equity, market-neutral equity, convertible bond arbitrage and macro. To date, just one small mutual fund group, Rydex, has decided to play in "alternative asset classes" through a combination of long and short (leveraged and unleveraged) index funds. That's sure to change soon, because the competition that mutual funds fear most, Exchange Traded Funds, can be margined and shorted easily. Separate accounts, with their high transparency, clear costs, and regulatory safeguards, offer a natural way for alternative managers, advisors and investors to work together.

Hedge funds are just another way to package asset management. For managers, the hedge fund package offers benefits such as incentive fees, lack of regulation, protection of trading strategies, and operational control. But for investors, separate accounts are usually a better package than hedge funds, assuming similar managers can be accessed both ways. Within a year or two, expect that assumption to become reality.

Don't repeat mistakes of the past. Help your clients evaluate hedge funds in a smart way with eyes wide open. Don't ever get so close to hedge funds that you compromise your objectivity and credibility.