Hedge funds are pulling in billions of dollars from institutional investors, even in a product that was initially geared toward affluent individuals.
Spurred by the need to diversify their portfolios during the worst of the bear market, foundations, endowments and pension funds are now responsible for the growth of both traditional hedge funds and so-called registered funds of hedge funds, more transparent versions of the lightly regulated investment pools that manage about $600 billion worldwide.
According to a study released last month by
and the Russell Investment Group, U.S. institutional investors put $17 billion into hedge funds this year, up from $12 billion in 2001, a 42% increase.
Between $550 billion and $650 billion is now invested in hedge funds. Funds of funds make up about 15% of the approximately 5,000 hedge funds now operating, according to industry estimates.
Funds of funds rode the bull market wave to 22.25% average returns in 1999, which piqued interest in them as a way to diversify portfolios and spread out risk. But the outperformance ended there: More recent returns on the TASS Fund of Funds Universe Average aren't as strong: 3.69% for 2000, 2.81% in 2001 and 2.85% in 2002.
They're up 7.91% through the end of September, and the strategy has another $5 billion at work from two years ago.
It's hard to determine exactly how much of that was put into funds of funds, but it is clear that institutions are now the sustaining force in a market niche that was originally intended to serve affluent, but not super-rich, individuals. Hedge funds may get lots of attention, but with laws restricting them to investors worth a net $1 million and who make at least $200,000 a year, it's a long way to go from owning a no-load mutual fund or a brokerage account.
Funds of hedge funds, the most common route to this type of investment for first-time investors, pool money in a single fund that allocates to a number of underlying hedge funds. With minimum commitments of $25,000 to $50,000, registered funds generally have lower investment requirements than unregistered hedge funds, which usually want $250,000 to $1 million.
Even if they are popular with professional money managers, a fund of funds remains a good idea for novice investors. Their managers sell themselves as professionals who know the single-strategy hedge fund market and can do the due diligence on each fund. Hedge funds are risky investments -- standard disclaimers use phrases such as "Returns from some alternative investments can be volatile" and "You may lose all or a portion of your investment."
A fund of hedge funds is no sure thing, and it's not cheap. Most charge a 1% annual performance fee, and can take another 10% incentive fee. This comes on top of the fees charged by underlying single-manager hedge funds; the typical management fee ranges between 1% and 2%, with a 20% incentive fee.
"That can really eat away at returns, and you really knock down the potential added value," says Lyle Benson, a Baltimore investment adviser.
One of the reasons institutions dominate the segment is that they can afford the fees, and they draw comfort from the
Securities and Exchange Commission
registration, which calls for increased scrutiny, requiring funds to have independent boards and periodic SEC examinations of funds and registration of individual investment advisers.
"It allows a little more sunshine, so to speak," says Mike Malloy, a partner and head of the investment management group at Drinker Biddle & Reath, a Philadelphia law firm.
Registered hedge funds have been around for a while, with offerings from OppenheimerFunds that date back to the mid-1990s, but it wasn't until the Internet boom showed its first signs of tottering that they really got traction.
UBS Paine Webber
Evergreen Investment Management
were among the highest-profile entrants into the registered hedge fund market. There are now about 80 such funds, according to Jim Dunn, vice president of Investorforce, a Wayne, Pa., company that keeps a database on hedge funds.
When registered hedge funds first started being popular two or three years ago, it was intended that the $1 million to $5 million investor would be the audience," said Judy Benson, a senior vice president at Financial Research Corp., a Boston consulting group. "It was thought that somebody might need a small allocation to an absolute return product, and these were launched with a tremendous amount of fanfare. What's happened now is that retail funds are still there, but the focus now is really on institutionally driven registered funds of hedge funds."
When the idea first came up, it had the trappings of high-end investment populism. Hedge fund managers, consultants and marketers figured they had a fine idea: file an SEC registration that allows more investors into each fund, lower the minimum investments and sign up the recently created "mass affluent" market segment for a little piece of hedge fund magic.
Surely, they thought, tens of thousands of new Internet-stock millionaires needed to diversify their portfolios with an alternative to stocks and bonds, and hedge funds' high returns turned the lightly regulated invest pools a hot topic.
But with the SEC registrations, marketers could tell people that hedge funds, while risky, could be a smart place to put 5% to 10% of their investable assets.
It would have taken a lot of work to capture the individual investor market, which left smaller fund managers at a disadvantage. While they may have been in better contact with a potential client base, they didn't have the advantage of established distribution channels, and creating those would have driven up already high costs.
"Very few firms have raised a lot of assets," James Hedges, president of LJH Global Advisors, a Naples. Fla., hedge fund adviser. "Most have money from their original sponsors but have not attracted substantial retail deposits. I think everybody is interested in this structure -- it's going to be a winner. But it's going to take a long time for these distribution channels to get comfortable."