Morningstar Advisor - Spring 2007 - (Page 28)

Spotlight: Hedge Funds Get the Strategy Minus the Headaches Other types of vehicles rush to offer small investors hedge-fund alternatives. by Gareth Lyons Advisor Jerry Plant recognizes that hedge funds could help diversify many of his clients’ portfolios. But he’s not in the market for one at this time. “I’ve looked at several multistrategy funds, but the illiquidity, the high entry threshold, the high fees, and the lack of transparency make hedge funds unattractive for many of my clients,” says Plant, CFA, of Mark I Asset Management in Oklahoma City, Okla. Plant’s comments echo what we’ve heard from other advisors. They might like what hedge funds could do for their clients’ portfolios but are wary of putting their clients into a largely unregulated, secretive, and expensive investment. The risk is too high. But for advisors such as Plant, the consolation is that there are viable hedge-fund (or, at least, hedge-fund-like) alternatives available. None of them is perfect, but they do award most investors with what they’re looking for from a hedge fund: a stream of absolute returns potentially uncorrelated to stocks and bonds. Funds of Hedge Funds: Easier Access at a Cost One major downside of investing in individual hedge funds is the time, effort, and money required to perform research and due diligence on them. “There are too many styles of hedge funds. You can’t be an expert unless that is the only thing you do,” says advisor Michael Carroll, CFP, of Wells Fargo Private Client Services in Colorado Springs, Colo. Investing through an intermediary via a fund of hedge funds, which Carroll does, is one way to sidestep this issue. Fund-of-funds shops perform due diligence on many hedge fund managers, employing a team of analysts to assess prospective funds for operational and investment proficiency. They then allocate assets across a passel of funds that use varying strategies, ranging from convertible arbitrage to equity long/short. Funds of funds come in various flavors, but the most common ones have multiple strategies, are well-diversified across managers, and aim to deliver steady absolute returns with low volatility. The benefits are clear. Diversification across styles and managers cushions against dreaded blowup risk and allows investors to tap into different strategies that could generate returns at various points in the investment cycle. Plus, there’s an advantage to investors pooling their resources with others. Size means a lot in the hedge fund world, and funds of funds often get access to managers who might otherwise be off limits for an advisor or individual investor. Investment restrictions aren’t as tight as they are for individual funds either. Funds of funds generally carry lower minimum investment requirements than those of individual hedge funds, and lockups rarely extend beyond 12 months. Also, fund-of-funds managers can enhance returns through tactical asset allocation, allotting a greater proportion to strategies or managers they think might outperform over the coming years. But there are downsides. Funds of funds tend to slowly adapt to shifting market conditions. Whereas an individual manager with a flexible asset base can seamlessly gravitate to different areas of the market for opportunity, the fund-of-funds manager is apt to make 28 Morningstar Advisor Spring 2007

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Spring 2007

Morningstar Advisor Spring 2007 Features Departments Letter from Joe Mansueto Get to Know Morningstar’s Fund Managers of the Year Is Your Client a Stock or a Bond? Less Alpha, More Beta Than Meets the Eye Your Mileage May Vary A Clear-Eyed Look at Hedge Funds Lower Risk, Higher Returns, What’s Not to Like? Without Cash and Clout, Advisors and Clients Get Short End of Stick Get the Strategy Minus the Headaches Analyzing Funds of Hedge Funds Not All Hedge Funds Are Created Equal A Fund with a (Long) View Laying Low and Prospering A Menu of Ideas to Fill Five Market Baskets Oil and Gas Gushing with Values Mutual Fund Analyst Picks Undervalued Stocks Most Popular Variable Annuities What’s New at Morningstar and on the Web You Can’t Always Get What You Want

Morningstar Advisor - Spring 2007

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