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Sorting Out the Belstar Fund

An unusual fee structure and the resumes of two of its managing directors bear some scrutiny.

Two stockbrokers who were once linked to the mutual-fund trading scandal are back on Wall Street with a cut-rate hedge-fund product that breaks with convention.

The Belstar Multi-Advisor Hedge Fund, whose managing directors include former Brean Murray brokers Ryan Goldberg and Michael Grady, will invest in a pool of seven to 15 hedge funds, a marketing brochure says. The vehicle is being offered mainly to institutions as a low-cost alternative to traditional funds of funds.

Belstar Group, the fund's adviser, is a relatively obscure investment firm created last year. Kenneth Orr, Belstar's chief investment officer, was a managing director at Philipp Brothers before founding an investment firm that bore his name.

The fund's marketing material doesn't mention Goldberg and Grady's previous employer, Brean Murray. The New York brokerage was investigated by the

Securities and Exchange Commission

for its role helping hedge funds carry out potentially abusive mutual fund trading strategies several years ago.

Brean settled the SEC's investigation without admitting wrongdoing for $150,000 in February 2005. Goldberg and Grady were never charged. However, documents in the SEC settlement say two brokers at Brean Murray negotiated about $1.8 billion of market-timing capacity for some of the scandal's biggest players, including Canary Capital Management. While the brokers aren't named, details from the settlement, as well as a lawsuit they filed against a former lawyer, indicate they were Goldberg and Grady.

"Michael and I were very small fish," Goldberg says.

The Product

Belstar's new product is a fund of funds, meaning it amalgamates money from investors and parcels it out to different hedge funds in an effort to diversify returns. Its marketing hook is the elimination of the traditional "double-layer" of fund-of-fund fees.

Belstar says its fund is "the first hedge fund to have no lock-up period," which is a mild exaggeration. Redemptions are allowed quarterly, as is the case with most funds.

It also calls the fund a "hedge fund," while in fact Belstar operates like a fund of funds, investing in managers rather than securities. The difference between Belstar and a fund of funds is that it is set up with so-called "managed accounts," says Goldberg. It means that Belstar owns each account it opens with each hedge fund instead of pooling its funds into the hedge funds. The structure is a bit less costly and more transparent.

Belstar will be distributed by Glocap Partners, a marketing firm affiliated with Glocap Search, a hedge fund executive search firm. Although Goldberg says that Belstar and Glocap are not affiliated, Orr is also a managing partner at Glocap Partners.

"The phone is ringing off the hook," says Goldberg. "Pensions and endowments are impressed with the single layer of fees. They want to maximize their profits."

Notwithstanding the hype, the product does make some sense. As fee structures are questioned by investors, some believe that this type of arrangement may be representative of a new trend.

"They are addressing this concern that fees are too high. Some believe that funds of funds are not providing enough added value for the amount of money they are charging," says Nir Yarden, a lawyer at Greenberg Traurig.

"We're willing to work for less than the rest of the business," Goldberg says. "We feel that that's what the market demands."

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The Innovation

Traditionally, funds of funds invest in a pool of managers that they select and whose performance they monitor. For that, they charge a management fee -- typically 1% of the assets -- and a performance fee, often 10% of the overall performance of the pool.

Problem is: funds of funds also pay a management fee and performance fee to the managers in which they invest, typically 2% and 20% respectively. And those fees are passed on to the investor. Adding it all up, the investor can end up paying a 3%-30% fee.

The set of 2% and 20% fees Belstar charges is, on its face, a better deal than 3% and 30%.

Funds of funds are also costly for a separate reason. Investors may have to pay even when their return is flat. Here's how.

Let's take a fund of funds investing half and half in two hedge funds. The first hedge fund generates a 50% return while the second's fund return is negative 50%. Overall, the net return is zero for the investor. And yet, the investor has to pay 20% of the 50% return.

The managers of Belstar will absorb this risk, which simply means that investors pay performance fees only on their net return. In this example, Belstar claims that it would eat the 20% levy. Goldberg says the firm also obtained a line of credit with Wachovia.

How is Belstar cutting costs and taking on more risk? Mainly by negotiating the lowest fees with the managers they take on board.

They also enroll managers that have lower costs themselves. For instance, foreign exchange or option traders are less expensive than equity managers. The fund invests in managers running fixed-income, currency, commodities, options and stocks strategies.

The fund currently has a roster of 10 managers. Five already had fees lower than the typical 2%-20%; three have cut their fees; and two charge full fees, Goldberg says.

One might logically wonder whether cheaper managers are inferior managers.

"By definition, good managers won't cut their fees. They have no reason to do that," says Mohnish Pabrai, managing partner with Pabrai Investment Funds. "In reality, the long-term performance of these managers is going to be worse than the other funds of funds because they are not going to be able to get the best managers in their pools."

Pabrai also questions the motives of hedge funds that would cut a better deal with a fund of funds, putting their other investors at a disadvantaged position. "It's certainly legal, but I question whether it's ethical."

"There is a quality issue associated with this arrangement. It may be attractive for start-up hedge funds or small funds," Yarden adds.

To be sure, Belstar's blueprint has been pursued by investors with impeccable reputations.

Arden Asset Management, the multibillion fund of funds, offered an all-inclusive fee before the summer of 2003. In 2004, it re-established the customary 1%-10% fee. In a letter sent to its investors last year, Averell Mortimer, Arden's president wrote, "Although this all-in approach had some attractive features, it was a departure from market convention and we have found it to be administratively burdensome as well as confusing to some of our clients."

Regarding their own reputation, Goldberg downplayed the mutual fund probe. He said his and Grady's employment at Brean Murray was left out of Belstar's marketing material because the firm was relatively unknown.

"We were part of an investigation of thousands of people," Goldberg said. He said he and Grady play a "minimal" role at Belstar compared to Dan Yun, the managing partner, and Orr, who is chief investment officer. Goldberg noted that Yun conducted a background check on him and Grady prior to hiring them.

Yun said: "What happened is unfortunate. They were part of a big dragnet. My lawyers said it's a non-issue."

Asked if his and Grady's background has impeded Belstar's ability to raise funds, Goldberg said: "Absolutely not. We were never brought in for any wrongdoing."

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