Morningstar Advisor - Spring 2007 - 76

The Phillips Curve You Can’t Always Get What You Want by Don Phillips When advisors cite the Harvard or Princeton endowment’s use of hedge funds as the rationale for their own experimentation with alternative assets for their clients, I think of Keith Richards. How many would-be rock stars have died trying to live the Rolling Stones guitarist’s lifestyle, but without access to the bodyguards, high-quality narcotics, and Swiss blood transfusions that have kept Keith alive? Advisors today simply aren’t privy to the same quality of hedge funds that the big boys are, nor do they have the power to negotiate fees, the way a David Swensen at Yale might. Imitation may be the sincerest form of flattery, but it can also be dangerous to your health or wealth. Admittedly, the theoretical case for hedge funds can be compelling. Yale Professor Roger Ibbotson and Ibbotson Associates President Peng Chen demonstrate as much in their recent research paper, The A, B, Cs of Hedge Funds: Alphas, Betas, and Costs. Even after adjusting for survivorship bias, they find that over time hedge funds have provided a return after fees between that of stocks and bonds, with a standard deviation less than half that of long-only equity exposure. This risk-reward combination led to significantly positive alpha that roughly equaled the level of the fees the funds charged. In other words, of the prefee alpha being created, half was taken by the manager and the rest flowed through to investors. That sounds like a reasonable value proposition. Add that to the promise of an uncorrelated asset class to better diversify portfolios, and you’ve got good reason to explore alternative assets further. However, as hedge funds do not operate on as level a playing field as mutual funds, it’s difficult to know which advisors have access to which funds. Often, access is a function of whom the advisor knows socially or with whom the advisor’s firm has cut a special deal. The one universe of hedge-like strategies that all advisors have access to is the group of 1940 Act mutual funds that engage in hedgefund-like practices. This group of approximately 100 funds covers activities ranging from mergers and acquisitions and long/short strategies to market-neutral and short-only funds. Providers include Franklin Templeton, Rydex, JP Morgan, and Gabelli, among others. Taken together, they give us some idea of how hedge-fund techniques have translated to the retail level. Period Total Return (Time-weighted) Investor Return (Dollar-weighted) hedge funds, the net result to retail investors was a fraction of what they would have gotten if they’d left their money in cash. Indeed, for each of these three time periods, the Vanguard Short-Term Investment-Grade Fund VFSTX had a higher return than the investor return for these funds as a group. There’s certainly potential in hedge funds, but the field today is very much a seller’s market and the best deals aren’t going to the financial planning community. Of course, the same disadvantages once existed in long-only mutual funds, where great managers worked at low costs for big institutions, but were available to advisors only in costly retail versions. But advisors like Harold Evensky and others stood up for their clients’ rights and demanded improved pricing and access. The mutual-fund industry responded by increasing transparency and by making institutional shares available to the planning community, thus allowing advisors to play on a level playing field with big institutions. Until hedge-fund purveyors follow suit, the best option for advisors seeking fair access to hedge funds may be to just say no. Why pay a premium to be treated like a second-class citizen? After all, you can get an uncorrelated, low-risk, single-digit rate of return from a money-market fund—a choice that, over the last decade at least, would have been more profitable for your clients than most retail hedge-fund strategies. K 3 Years 5 Years 10 Years 3.02 2.55 7.69 2.22 0.30 4.13 Data as of Dec. 31, 2006. Returns are annualized. As seen above, the results aren’t pretty. The simple average returns for both the trailing three- and five-year periods are less than you would have received in a money-market account. The investor, or dollar-weighted, returns, which take into account the timing of shareholder purchases and sales are even worse. The 0.3% five-year investor return is particularly disturbing as it includes the bearish 2002. If there was ever a period where the ability to short stocks should have helped, this was it. And yet, with all the hype around Don Phillips is Morningstar’s managing director, corporate strategy, research, and communications. 76 Morningstar Advisor Spring 2007
Morningstar Advisor - Spring 2007

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