Morningstar Advisor - Spring 2007 - 27

volatility and lower-return performances. Some say that the reason for this trend is the increasing number of institutions entering the market. Many institutions strongly value low volatility. It is also possible that many hedgefund strategies are simply getting crowded— making it harder for managers to exploit inefficiencies and generate large amounts of alpha—and that hedge funds are shifting to Plan B strategies with lower risk and return. What Should an Advisor Do? A second option for advisors and investors is to combine forces by paying for the research of a respected and trustworthy independent firm that performs due diligence on hedge funds. Morningstar is doing just that on select hedge funds, and our reports are published in our institutional product, Morningstar Direct. This eliminates many of the issues outlined in this article, but investors are still limited to the subset of funds that will accept their money and that the independent researcher covers. A third alternative is to eschew individual hedge funds in favor of more-accessible funds of hedge funds, hedge-fund-like mutual funds, or an investable hedge fund index. Each of these options has some attractive features, but each comes with downsides, too. (See the following article.) Ultimately, hedge funds have appeal for good reason. They can have low correlation with traditional asset classes, lower a portfolio’s volatility, and provide positive returns during adverse market conditions. But individual hedge funds carry risks, even for the most sophisticated institutional investor. Smaller investors, such as advisors and individuals, who lack the resources and clout institutions have, face these same risks, yet must also traverse another layer of pitfalls. In the end, as with any investment, if you’re not comfortable investing in hedge funds, don’t do it. Between other hedge fund products, not to mention stocks, bonds, mutual funds, and real estate, advisors and their clients have many good investment alternatives and ample opportunities to diversify their portfolios. K Advisors considering hedge funds for their clients are left with three options. One is to go in with your eyes wide open, aware of these issues, but still willing to set aside some portion of a portfolio with individual hedge funds—whether you’re a gunslinger looking for outsized returns or a conservative investor looking for an investment that is not correlated to your other assets. This tack is tempting, but because of the issues raised in this article, the success of such a strategy is a low-probability event. Daniel Farkas is a hedge fund analyst with Morningstar. Join Morningstar’s team of hedge fund analysts online as they answer questions from advisors about investing in hedge-fund strategies. The live chat will take place at 3:30 p.m., Central time, June 6 at http://advisor.morningstar.com/hedge. 3 Credit spreads rose to high levels in 2002 and then dropped for the next 2.5 years. 4 Short-term interest rates were low and falling. 5 The dollar peaked in the early 2000s and fell precipitously for most of 2002 and 2003. U.S. Credit Spreads (High Yield minus Government bond) 30-Day U.S. Treasury Returns U.S. Dollar In Euro 6.66% Dollar Value in Euros Annual Yield Annualized Returns 1.12€ 7.73% 3.01% 2.00% 0.74€ 02 03 04 01 02 03 04 02 03 04 MorningstarAdvisor.com 27

http://advisor.morningstar.com/hedge http://MorningstarAdvisor.com

Morningstar Advisor - Spring 2007

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