Hedge Funds Back In Style, What Advisors Should Know
Remember him?
Like it or not, hedge funds are making a comeback. After taking a nasty fall post-Madoff, the hedge fund industry’s assets are approaching their historical peak with $1.917 trillion in the 4th quarter of 2010.
That’s slightly shy of the the 2008 peak when the industry held assets of $1.93 trillion in the second quarter that year. Of course, we all know what happened in the later half of that year. Lehman Brother fell, unprescedented M&A deals were signed and sealed within a weekend’s time, billions in bailout dollars were handed out.
Hedge funds were hit hard as investors rushed to redeem their investments. More than 1,400 funds shut their doors in 2008 and another 1,000 shut down in 2009.
The latest data indicates a massive bump in assets in the industry. According to HFR, investors committed $13.1 billion net new capital to hedge funds in 4Q bringing total 2010 net inflows to $55.5 billion, the highest annual total since 2007.
But as investors slowly warm up to the alternative asset class once more, Matthew Helfrich, chief investment strategist with Waldron Welath Management has some advice for investors and their financial advisors: don’t forget about the due diligence.
Here’s Helfrich in his own words:
Two years after the Madoff scandal, financial advisors and their clients find themselves at a crossroads with respect to hedge funds of funds, even as this industry continues to fight an uphill battle to regain investor trust. Looking past the current public cynicism about the hedge fund of funds industry, it is incumbent on financial advisors and their clients to bear in mind that the need for non-correlating asset classes will never change, and hedge funds of funds still provide this effective source of diversification.
The fact is, when seeking to achieve successful diversification amongst the asset classes and high-quality managers, investors either need a $100 million portfolio or a quality fund of funds manager who can provide effective due diligence and allocation of capital. The universe of hedge fund asset classes is very deep and includes convertible arbitrage, distressed mortgage, long-short equity and global macro, among many other complex strategies. These are all vitally useful strategies.
Where too many financial advisors and their clients went wrong with respect to the fund of funds industry can be summed up in one word: Assumptions. They assumed that all hedge fund vehicles would provide absolute returns regardless of market conditions, that they were completely transparent if the fund manager said so, and they would provide liquidity if a redemption was met. Today, we are all familiar with the grim outcome that resulted from these assumptions.
What is the solution? The right amount of, and approach to, due diligence. The following is an “all weather” due diligence checklist for financial advisors when it comes to fund of funds investments:
- Ask the right basic questions. Advisors need to understand the team that is investing their clients’ money. How long has the team been investing in hedge funds? What did the manager do before he or she invested in hedge funds? How long has the team been together? Did anyone leave the team, and if so, why? These are just the basic questions needed to gain a baseline perspective of the people who will be allocating your clients’ capital.
- Be wary of managers claiming “access.” Sound diversification does not include access as an investment solution for your clients. “Access” typically involves chasing the most recent winners. Rebalancing 101 has always told advisors that they should be taking money from their “winners” and allocating to their “losers.” As we’ve all heard, “when everyone talks about making a killing, the market is already dead.”
- Ensure open access to underlying managers. Your fund of funds manager should allow and encourage you to talk to the underlying managers on the platform. Hedge fund managers are not the Wizard of Oz. It is important that you hear from the underlying managers regarding their interactions with your fund of funds manager. Verify the quantitative and qualitative due diligence that was allegedly done.
- Verify transparency to the position level. Your fund of funds manager should have full visibility into underlying managers’ activities, to ensure there is not an over-concentration of risk within a particular theme.
- Confirm independence. Your fund of funds manager should have an independent auditor, custodian and administrator. These are easily verifiable facts.
- Check SEC registration. The SEC has been under the gun lately for past missteps, but at the end of the day, your fund of funds manager needs to be registered and needs to have been through an examination by the regulators. Ask for the results of the last examination, and review them carefully.
- Know all details regarding gates and liquidity terms that can be imposed. Everyone was caught off guard by their hedge funds denying an exit. The documents say managers have the right to gate in order to protect all investors. Advisors need to read the documents. It is paramount that advisors understand the investments and educate their clients about the risks of hedge funds. Educating includes discussing end asset allocation decisions and not over-exposing clients to alternative investments.
- Understand the fee structure. The biggest argument against hedge funds is the layering of fees. Understand how the managers are paid. Is your manager sharing fees with his or her underlying managers, creating a high water mark? No one will question fees unless there is an absence of value. Managers are not paid to source hedge fund ideas. They are paid to be effective advisors of alternative investment capital and they deserve to be paid if they are successful.
- Observe your funds’ activity and allocation philosophy. Fund of fund managers are often blamed by the industry as “hot money” and “performance chasers.” Ask for managers’ activity. How often do they make changes? Why do they make changes? How much notice do they provide? You don’t want an industry pariah.
- Confirm a proven track record of success. While Past performance is no guarantee of future results, This is the final point because if the team, processes and philosophy of the manager all make sense, the appropriate performance should follow. It can’t be stressed enough. If you focus on performance first, you leave yourself open to disappointment. ‘Fund-of-funds’ mutual funds are exposed to the same risks, including loss of principle, as the underlying funds in direct proportion to the allocation of assets among those funds. Asset allocation does not assure a profit or protect against loss in declining markets
The above is just a core starting point. The hedge fund industry is extremely diverse and opaque, andhedge fund of funds are complicated investments that deserve extra attention, but the industry is by no means broken. Advisors simply need to be diligentabout doing their research and homework to find the most appropriate solutions for their clients.
Matthew Helfrich, CFP® is Chief Investment Strategist at Waldron Wealth Management (www.waldronwm.com), an independent multifamily office and private wealth counseling firm with over $2 billion in brokerage and advisory assets under advisement, and affiliated with LPL Financial.
