Hedge Funds for the Not-So-Rich - TheStreet

They're not exactly McHedge Funds, but financial services companies have begun rolling out a number of hedge funds aimed at the rich, rather than the really

really

rich.

But like the glitterati who fly their own planes, just because you have the wherewithal to do something, doesn't mean you should.

The allure of hedge funds is obvious. These barely regulated funds use a variety of strategies -- such as short sales, options trading, arbitrage and currency bets -- to consistently outperform the market. And in recent years, they have: In 2001, the average U.S. hedge fund (as measured by Van Hedge Fund Advisors U.S. Hedge Fund Index) returned 5.6%, while the

S&P 500

fell 11.9% and the average equity mutual fund fell 12.6%.

In 2000, the difference was even greater: The average hedge fund return was 11%, while the S&P and average equity fund fell 9.1% and 5.2%, respectively.

But there are a few problems with those numbers. One is that hedge funds' low correlation with traditional asset classes works best when those asset classes are performing poorly. In 1997 and 1998, for example, the S&P roundly trounced hedge funds -- 33.4% to 20.9% in 1997 and 28.6% to 11.7% in 1998.

The other, more important, issue is the myth of the "average" hedge fund. Indeed, there's not enough data reported to determine a true average.

Unlike mutual funds, hedge funds are not registered with or regulated by the

Securities and Exchange Commission

. Consequently, they're not required to meet any sort of transparency or disclosure rules, nor are they permitted to advertise. (Research and advisory firms like Van Hedge Fund Advisors and the Hennessee Group work solely with funds that voluntarily disclose their holdings and performance figures.)

Hedging a Good Bet
Hedge funds outscore S&P 500

Source: Van Hedge Fund Advisors

Arguably, it's the best-performing funds that choose to do so, which means that "average" figures are somewhat arbitrary and perhaps inflated.) Because of the different structure of hedge funds, they usually have fewer investors, but these pony up big bucks. Investors generally must meet certain income and net worth tests: more than $200,000 in income for at least two consecutive years and a net worth of $1.5 million. Most have required minimum investments of $1 million. Until now, that is.

In an effort to capitalize on the hedge fund mystique, several companies have begun seducing investors with more accessible hedge funds, often with lower minimum investments.

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CIBC World Markets, for instance, completed the $90 million initial public offering for its Advantage Advisers Multi-Sector Fund on April 22. The multisector, hedged equity fund invests in three of the largest segments of the U.S. economy: health care/biotechnology, banking/financial services and technology. The fund is aimed at investors with at least a $1.5 million net worth, but has just a $25,000 minimum investment.

"Alternative investments for high net-worth individuals is where the most growth and the most demand is," says Craig Goos, executive director of alternative investments at CIBC.

The Advantage Advisers fund, though, is actually more of a mutual fund wrapped around a hedge fund. "It's structured like a closed-end mutual fund, yet it has underlying hedge fund managers running the fund," Goos says. Consequently, it's subject to the same disclosure and related regulations as all mutual funds.

CIBC's fund, while unique, isn't without competition. Pioneer Global Asset Management announced last week that it acquired U.K. hedge fund group Momentum, for $110 million. Pioneer plans to introduce several hedge funds, aimed at a "broad array" of investors, a Pioneer spokesperson said. Other 2002 newcomers include Montgomery Partners' Absolute Return and Oppenheimer Tremont Market Neutral funds, both of which have $25,000 minimum investments.

In addition, American Express Financial Services and Charles Schwab have entered the fray -- making hedge fund investing almost as easy as purchasing a mutual fund. American Express offers five funds, which it began introducing in 1999; Schwab plans to roll out three or four funds of funds this year. Like funds of funds in the mutual fund world, these hedge fund products each would invest in an assortment of hedge funds.

Too Much of a Good Thing

Investors still would do well to be wary of the increasing array of hedge funds. "Just because you don't need to invest $1 million doesn't mean hedge funds are a good idea," says Peter DiTeresa, a senior analyst at Morningstar. "Even if you have $1 million to invest, hedge funds may not be a good idea."

Belying their category name, hedge funds can often be quite risky. The positions held are frequently illiquid, which is why most limit investor redemptions. And because there's generally little disclosure, investors can be caught unaware as to management decisions and strategy.

Late last year, for instance, Kenneth Lipper, the man behind two convertible-arbitrage hedge funds -- assured investors that the funds had risen in value. In February, he admitted that they had actually lost $315 million in 2001. April brought more bad news when Lipper liquidated the funds, the U.S. fund at a 45% loss. That sounds bad, but it's even worse given that convertible arbitrage -- in which a manager purchases undervalued convertible securities (typically, bonds that can be converted to stock), while simultaneously selling short shares in the same company -- is considered one of the least risky strategies hedge funds employ.

Once you've become an investor, however, hedge funds will provide greater disclosure, although few -- if any -- are as transparent as mutual funds. And while a greater number of hedge funds are reporting to the likes of Van Hedge Fund Advisors and the Hennessee Group, not all see increased disclosure to the outside world as a goal. "The area of transparency is not one of great demand," says Leroy Cody, managing director of American Express' alternative investments group. "We've been able to provide clients with sufficient transparency for their needs."

There's also the matter of expense. Hedge funds are pricey -- even those designed to appeal to a wider swath of investors. The average mutual fund has an expense ratio of 1.37%, whereas it's not uncommon to find hedge funds with expense ratios of 2%. (Again, the lack of regulation makes it impossible to determine industry averages.) That may not sound like much, but that's almost an extra $7,000 difference on a $1 million investment -- annually. Add to that the sizable manager fees: Managers generally take some 20% to 30% in performance fees. Even CIBC's Advisers' fund has a 5% sales load, a 1.25% management fee and a 20% performance fee.

Hedge funds of hedge funds, designed to spread the risk across several hedge funds, may not make much more sense, DiTeresa says. "It's an intriguing idea, but in principal a hedge fund is a one-stop shop; they should be able to make money in any market," he says. "If the point of a hedge fund of hedge funds is to diversify risk, it implies that the hedge fund concept is maybe not that compelling after all." In addition, funds of funds generally impose higher fees.

Despite the invitation to a (somewhat) exclusive club, the high risk and high cost of hedge funds should give nearly any investor pause. "Think about how much of your portfolio you're comfortable saying to a manager, 'OK, just go to town,' " DiTeresa says.