It's Gloomy In These Hedges

For retail investors, hedge funds of funds aren't paying off

A few years back, everyone wanted to invest in hedge funds, but not everyone could meet these private partnerships' seven-figure minimum purchases. So Wall Street set up hedge funds for the merely affluent and registered them with the Securities & Exchange Commission, a move that allows the funds to admit an unlimited number of investors and keep investment minimums in the $25,000 to $100,000 range. Since 2001 more than $3 billion has been raised for these so-called funds of funds, which pool investors' dollars and spread them across a dozen or more hedge funds for diversification and to minimize the consequences of a fund blow-up.

How have these funds fared? By and large, investors would have made more money with a Standard & Poor's 500-stock index fund (table). That's partly because the hedge fund investments saddle investors with high fees -- as much as 5% a year. Moreover, with many managers engaging in rapid-fire trading, these sorts of investments can generate hefty tax bills. "Generally speaking, for a taxable investor, it's difficult to get any meaningful out-performance," says Nelson Lam, a fee-only registered investment adviser from Lake Oswego, Ore.


Another reason for their unimpressive numbers is that most of these funds aim for modest annual gains -- ideally, in the high single digits -- regardless of whether stocks rise or fall. The idea is that when stocks head south, such an "all-weather" investment preserves capital, leaving a bigger portfolio to work with when the good times resume. "Our fund is built for investors who want to diversify and protect themselves against down markets," says Greg Stahl, chief investment strategist at SEI Investments, sponsor of the SEI Opportunity Fund, which earned an average annual return of 7.11% from its inception in June, 2004, to June, 2006. "We're not for those with an aggressive risk profile."

Sizing up the performance of these funds is not easy. While most hedge funds are not required to publicly disclose their numbers, those that register with the SEC must -- albeit only twice a year and sometimes with as much as a 90-day lag. That means reports for Sept. 30 may not be available until December.

A BusinessWeek analysis of performance data culled from SEC filings reveals that the average SEC-registered fund of funds with a minimum of $25,000 to $100,000 and a fiscal year that ends on Mar. 31 -- when the majority close their books -- returned just 6% a year over the four years through Mar. 31. In contrast, the S&P rose an average of 7.2% a year during that period. The HFRI Fund of Funds Composite Index, composed of 850 hedge funds of funds with an average minimum of $720,000, gained 7.9%. (Returns are net of fees, but not taxes).

Those investors who did best in these lower-minimum hedge funds are those who bought during the bear market. For the fiscal year that ended on Mar. 31, 2003, the few of these hedge funds around were about flat, while the S&P was down nearly 25%. Even so, an investor who put $50,000 in the Oppenheimer Tremont Market Neutral Fund on its first day of operations, Jan. 2, 2002, would have amassed $57,872 by Mar. 31, 2006, vs. $60,448 in an S&P 500 fund. Of the ten other SEC-registered funds of funds that date back to the bear market, eight show similar results: Assuming a purchase was made on the funds' launch dates and held through Mar. 31, the investor would have fared better with an S&P 500 fund.

For at least some of the SEC-registered funds of funds, the performance woes are likely to continue. SEC filings reveal that several had invested from 3% to 7% of their net assets in Amaranth Advisors, the Greenwich (Conn.) hedge fund that recently lost about 60% of its value on bad bets in the natural gas market. Among them: the Mercantile Absolute Return Fund, the BNY/Ivy Multi-Strategy Hedge Fund, the Credit Suisse Alternative Capital Multi-Strategy Fund, Deutsche Bank's (DB ) Topiary Fund for Benefit Plan Investors, and the newly launched Morgan Stanley Alternative Investment Partners Absolute Return Fund. Brett Lane, manager of Mercantile's alternative investment business, says with two dozen hedge funds in the portfolio, "it's premature for us to speculate on what the September performance is going to look like." Spokesmen for the other funds declined to comment.

Of course, a prolonged and nasty bear market would turn the tables, helping these sleepy funds overcome their performance deficits -- and then some. Nonetheless, since the stock market tends to rise twice as often as it falls, such investments "have got to do well on the way up, or they're just not going to be attractive" long-term propositions, says Todd Trubey, an analyst at Morningstar.

The 40 mutual funds in Morningstar's "long-short" category, which use hedge fund strategies, have not fared well, either. The average annual return for the three years ended Sept. 30 is just 6.1% vs. 12.7% for all domestic stock funds. Yet, if you're interested in a hedge fund sort of play, you're better off with a mutual fund .

Why? They allow investors to get performance information and liquidity on a daily basis. SEC-registered hedge funds of funds only permit periodic redemptions -- quarterly arrangements are common. The mutual funds generally cost less, too, with expense ratios that average 2.2% a year.

Still, investors have many cost-effective ways to diversify. Lam, for one, recommends buying real estate investment trusts, international small-cap stocks, commodities, and plain old bonds -- all of which don't always move in sync with stocks and most of which are available via low-cost index funds. By leaving hedge funds to the wealthy, the merely affluent may wind up wealthier in the long run.

By Anne Tergesen

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