Brokerages Hedge Offerings Amid Tumult

This just in: Wall Street is catering to the rich.
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It might not be the return of the Old Boys' Club, but Wall Street's experiments with populism are looking less and less affordable these days.

In a bid to bulk up assets under management and collect fatter fees, U.S. brokerages and asset managers are back to trying to woo and keep rich clients by offering hedge-fund products, among other things. The offshore, thinly regulated investment vehicles have outperformed other investment alternatives this year and have never been more popular with the wealthy. For brokerages, selling the funds means wider margins than traditional equity products -- a business that has become a drag on industry profits following the market downturn.

Charles Schwab

(SCH)

announced last week it plans to begin offering its investors a choice of third-party hedge fund products within the next 12 months. It's uncharted ground for Schwab. Once billed as a discount brokerage, the company has been eager to expand into more sophisticated (and profitable) lines, and already offers a number of products for the rich through its U.S. Trust arm. "We want to offer a wider choice of funds to our affluent clients," a Schwab spokesman said.

With returns pinched by the tough market, the funds themselves are looking for a way of generating more revenue, according to Meredith Jones, an analyst with Van Hedge Funds. "A lot of people who have in-house clients are looking to create hedge fund products because they know that high net-worth individuals are interested in that, and they want to capture that interest rather than lose them to other funds. It's hard to find anyone who hasn't thought about

opening a hedge fund, from brokerage houses to national banks to regional banks in the last 12 to 18 months," she said.

Firms like

Bank of America

(BAC) - Get Report

and

ING Asset Management

have added hedge fund products in the past two years, as have several German outfits, including

Deutsche Bank

(DB) - Get Report

and

Dresdner Bank

, David Friedland, president of Magnum U.S. Investments, said.

Hedge funds, which in their purest form reduce risk by shorting equities and derivatives, are relatively unregulated, but are accessible only to individuals with a liquid net worth of $1 million or more, according to U.S. law. That means the hedge fund door is shut to your average retail investor. A hedge fund typically earns 3% of assets managed in fees, vs. 1% to 2% for your average equity mutual fund. But the real cake is the commission on performance, which can run at an additional 7% or more on assets. In Schwab's case, these commissions would go to the third-party manager of the hedge fund.

Return of the Hedges

The push to offer hedge fund products isn't new. The acceptance of hedge fund investing by institutional investors like pensions has helped bring the business into the mainstream, while the stock market decline and volatility have given hedge funds an edge in terms of performance.

"In the early '90s, anybody could make money. But since 1998, the buy-and-hold strategy has brought zero returns. In this environment, aggressive trading rather than buy-and-hold strategies win, and that's when hedge funds work. Mutual funds, meanwhile, are trying to minimize their trading activities," said Reilly Tierney, senior vice president of Fox-Pitt, Kelton.

The hedge fund industry is currently growing at record levels of over 20%, while the number of funds actively investing is close to 6,800, says the Securities Industry Association's chief economist, Frank Fernandez. At the end of last year, the industry was managing an estimated $600 billion in total assets. The hedge fund business is booming in Europe, too, where some estimate 60% growth in the first 6 months of the year. In Europe, hedge funds are replacing Swiss banks as havens for Europeans in light of new banking treaties that limit the tax benefits of certain accounts.

Analysts say the business will thrive to the extent that the equity markets remains volatile and depressed. Hedge funds' ability to preserve capital in the wake of the terrorist attacks, and their outperformance of the indices during September, caught a lot of eyes and should increase investor interest over the next 3 months to 6 months, said Jones of Van Hedge Funds.

Using hedging strategies and a bet that the difference between short- and long-term interest rates would increase, many hedge funds generated big gains during September. In fact, over 38% of the hedge funds reporting for the Van Hedge Fund's Index posted gains in September, and over 46% turned in profits for the quarter. Some 88% of hedge funds outperformed the

S&P 500

during the third quarter. By comparison, the S&P 500 fell 8.1% in September and 14.7% in the third quarter, while the

Dow Jones Industrial Average

lost 11.0% for the month and 15.4% in the third quarter. The

Nasdaq

declined 17.0% and 30.6% for the month and quarter, respectively.

Analysts agree the offerings aren't a panacea for the brokerage industry. "It's still a pretty small subset of product line. You can double the revenue base from hedge fund products and still not make up for losses in other areas," says Diana Yates, securities analyst at A.G. Edwards & Sons. "I'm more worried about investment banking and IPO activity." The industry is expected to record earnings of $8 billion in 2001, down from $21 billion in 2000, according to the Securities Industry Association.

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