Morningstar Advisor - Spring 2007 - 24

Spotlight: Hedge Funds Without Cash and Clout, Advisors and Clients Get Short End of Stick Only the most attractive investors get picked for the best hedge clubs. by Daniel Farkas Lack of transparency, operational risk, high fees and minimum initial investments— every investment professional who’s ever looked at hedge funds knows these drawbacks. They bring uncertainty to hedge fund investing and raise the bar for the gross returns an investor requires. They affect investors of all stripes and at all wealth levels, whether the investor runs a huge pension fund or is a high-net-worth client of an advisor. But for advisors and their clients, there is an extra layer of problems that the big players don’t necessarily have to deal with. They are snags that make investing in individual hedge funds, already a complicated and difficult process, particularly thorny for advisors. Here are six issues that advisors must tackle. 1. High Minimums, Low Chance to Diversify Consider the advisor who has $1 million to allocate to hedge funds on behalf of a client. The advisor may be limited to only a couple of suitable funds. Even though hedge funds would only make up a portion of an otherwisediversified portfolio, most investors, and their advisors, are likely to prefer more than one or two funds for the hedge fund portion of their portfolios. 2. Aspiring for a VIP Room, Settling for the Neighborhood Bar digit minimum initial investments and lockups that stretch for three years. These terms ensure that hedge-fund managers will have fewer administrative and investor-relations costs and headaches than if they let in smaller investors. They also put some of the most successful hedge funds out of reach for the vast majority of individual investors and advisors. Taking this point a step further, some hedge funds are known to declare that they are “closed,” only to accept new money from large institutional clients or longtime fund-of-hedgefunds clients. Here is another instance of individual investors being left behind. In the end, they are left to choose from the set of funds that are willing to sell to them. What did Groucho Marx say about not wanting to join a club that would accept him as a member? 3. Getting Information: Call Jack Bauer Moreover, the client with $1 million would be limited to choosing hedge funds with the smallest minimum initial investments. The investor’s opportunity set is smaller and, therefore, inferior to the universe of funds available to institutional investors, who are free to seek out the best managers, regardless of minimum investment levels. Also, many of the best hedge funds set up a “velvet rope”—only the most attractive investors make it into the club. The most sought-after managers face a demand that exceeds the amount of the fund they want to sell. One result is that such funds are able to require tough investment terms, such as eight- To get into the game, most hedge funds require minimum initial investments ranging from $500,000 to $5 million. That’s a huge chunk of change for most clients. And it doesn’t give advisors the same opportunities to build a diversified mix of hedge funds that institutional investors have. Although hedge funds are notoriously secretive, there remains information to be mined. Advisors and investors who have the wherewithal to perform thorough due diligence are in a much better position to successfully invest in individual hedge funds than investors without such information. Unfortunately, many 24 Morningstar Advisor Spring 2007

Morningstar Advisor - Spring 2007

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