Following Wealthy Investors Isn't Cheap
The investments known as "funds of hedge funds" offer cachet and the lure of smooth returns, but those benefits typically come at a steep cost. These investments aim to put hedge funds -- lightly regulated investment vehicles for the very wealthy -- into packages that are also appropriate for the merely wealthy. While some advisers have warmed to these packages of funds, pointing to their ability to provide attractive returns even in rough markets, others remain skeptical -- citing drawbacks such as complicated rules for withdrawing money, hard-to-evaluate performance records and fees they consider too rich.
Funds of hedge funds have grown rapidly, with assets more than doubling to $750.1 billion since 2004, according to data company Hedge Fund Research Inc. The company estimates that about one-third of all the funds it tracks have minimums below $100,000.
Minimums for funds of hedge funds tend to be lower than those of hedge funds, often in the tens of thousands of dollars rather than hundreds of thousands or millions.
While some hedge funds aim to shoot out the lights, taking risks to post huge returns, often their goal is steady gains in any kind of market. Assets in funds of hedge funds really gained steam in 2002, when many funds posted healthy returns amid a dismal year for the stock market.
"The expectation, the hope is to deliver similar returns to the public equity market with less volatility," says Paul Weisenfeld, part of a Citigroup Inc. team that vets funds of hedge funds for Smith Barney financial advisers.
Mr. Weisenfeld says that, among Smith Barney clients who own hedge-fund investments, allocations of 5% to 10% of their portfolios are common. The hedge-fund group maintains a slate of about 55 different funds for advisers to choose from.
Trading Secrets
Financial advisers at independent firms have to do the leg work on their own, a task that can be complicated by restrictions on hedge-fund marketing and fund managers' own reluctance to reveal details of their operations.
Sam Sudame, chief investment officer of registered investment adviser Schultz Financial Group Inc., in Reno, Nev., invests in a mix of different hedge funds to create "all weather" portfolios. Without an in-house research department available to clients at a major brokerage firm like Smith Barney, Mr. Sudame mines for prospective investments at conferences arranged by prime brokers, firms that provide trading services to hedge funds.
He also subscribes to an online service that provides him with information about hedge-fund returns, such as financial ratios. Still these tools can't be substitutes for ringing door bells.
"Every manager must be met," he says.
Along with the promise of funds of hedge funds, there are significant drawbacks. One key sticking point: restrictions on when investors can pull out their money. Restrictions on withdrawals can resemble those imposed by hedge funds, since money being withdrawn from funds of funds ultimately has to come out of hedge funds.
"At best you can get out monthly or quarterly, but semiannually is more common" for funds of hedge funds, says Citigroup's Mr. Weisenfeld. Investors also have to plan ahead, he says, since many funds have a notice period of 30 to 90 days. The restriction can be particularly vexing because many hedge funds also wait several weeks to report results.
Many funds have reported results for August only in the past few weeks. That means investors alarmed over poor returns in that rocky month might have found out the numbers only recently and could still have to wait until the new year to exit their investments.
Fees can also be a sticking point. The classic hedge-fund fee structure is "two and 20," that is, fund managers charge 2% of assets a year as a management fee as well as 20% of the profits.
The bite can be lessened by "high water" and "hurdle" clauses, which limit the circumstances in which performance fees are paid. However, funds of hedge funds offer another layer of fees, often a flat 1.5% of assets a year, or a 1% management fee and 10% of profits.
Funds of hedge funds have grown rapidly, with assets more than doubling to $750.1 billion since 2004, according to data company Hedge Fund Research Inc. The company estimates that about one-third of all the funds it tracks have minimums below $100,000.
Minimums for funds of hedge funds tend to be lower than those of hedge funds, often in the tens of thousands of dollars rather than hundreds of thousands or millions.
While some hedge funds aim to shoot out the lights, taking risks to post huge returns, often their goal is steady gains in any kind of market. Assets in funds of hedge funds really gained steam in 2002, when many funds posted healthy returns amid a dismal year for the stock market.
"The expectation, the hope is to deliver similar returns to the public equity market with less volatility," says Paul Weisenfeld, part of a Citigroup Inc. team that vets funds of hedge funds for Smith Barney financial advisers.
Mr. Weisenfeld says that, among Smith Barney clients who own hedge-fund investments, allocations of 5% to 10% of their portfolios are common. The hedge-fund group maintains a slate of about 55 different funds for advisers to choose from.
Trading Secrets
Financial advisers at independent firms have to do the leg work on their own, a task that can be complicated by restrictions on hedge-fund marketing and fund managers' own reluctance to reveal details of their operations.
Sam Sudame, chief investment officer of registered investment adviser Schultz Financial Group Inc., in Reno, Nev., invests in a mix of different hedge funds to create "all weather" portfolios. Without an in-house research department available to clients at a major brokerage firm like Smith Barney, Mr. Sudame mines for prospective investments at conferences arranged by prime brokers, firms that provide trading services to hedge funds.
He also subscribes to an online service that provides him with information about hedge-fund returns, such as financial ratios. Still these tools can't be substitutes for ringing door bells.
"Every manager must be met," he says.
Along with the promise of funds of hedge funds, there are significant drawbacks. One key sticking point: restrictions on when investors can pull out their money. Restrictions on withdrawals can resemble those imposed by hedge funds, since money being withdrawn from funds of funds ultimately has to come out of hedge funds.
"At best you can get out monthly or quarterly, but semiannually is more common" for funds of hedge funds, says Citigroup's Mr. Weisenfeld. Investors also have to plan ahead, he says, since many funds have a notice period of 30 to 90 days. The restriction can be particularly vexing because many hedge funds also wait several weeks to report results.
Many funds have reported results for August only in the past few weeks. That means investors alarmed over poor returns in that rocky month might have found out the numbers only recently and could still have to wait until the new year to exit their investments.
Fees can also be a sticking point. The classic hedge-fund fee structure is "two and 20," that is, fund managers charge 2% of assets a year as a management fee as well as 20% of the profits.
The bite can be lessened by "high water" and "hurdle" clauses, which limit the circumstances in which performance fees are paid. However, funds of hedge funds offer another layer of fees, often a flat 1.5% of assets a year, or a 1% management fee and 10% of profits.
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