Wall Street's wizards have concocted a new type of hedge fund that lets investors in for well below the standard minimum of $500,000 or more. With investors still reeling from the ravages of the recent bear market, the sponsors of these products expect them to be popular. After all, the average hedge fund eked out a 3.2% return last year using strategies such as short-selling and merger arbitrage, compared with the nearly 12% loss of the Standard & Poor's 500-stock index. Yet most people need to ask themselves whether the new funds are worth their high fees, especially since there are lower-cost mutual funds that can accomplish similar objectives.
These new hedge-fund products are really funds of funds, which invest in other hedge funds instead of individual securities. Funds of funds have existed for more than a decade, but the new ones have added a wrinkle by registering as closed-end funds under the Investment Company Act (ICA) of 1940. Registered funds can have an unlimited number of investors, so they can require minimums as low as $25,000. Unregistered funds can't have more than 100 investors and require high minimums to achieve any scale.
Only about 10 of these funds are operating, including three run by Global Asset Management and two by Oppenheimer Funds. Most were launched in 2001 (table). Many more are scheduled to open this year. "Hedge funds are going mainstream," says Charles Gradante, chief investment officer of Hennessee Hedge Fund Advisory Group. In fact, some of these new funds--by also registering under the Securities Act of 1933--will have the ability to advertise to the public. Traditional hedge funds can't do that.
The potential market for these funds is huge. By law, hedge funds can only accept "accredited investors" with at least $1 million in assets, but plenty of people who qualify still can't afford to plunk half of their assets into a hedge fund. According to a study by Montgomery Asset Management, 90% of millionaire households have assets in the $1 million to $5 million range. Those 7.4 million households are the primary targets for funds such as Montgomery Partners Absolute Return and Oppenheimer Tremont Market Neutral Fund.
Still, the lower-minimum funds are no bargains. Montgomery's is typical, charging an annual management fee of 1% of assets plus an incentive fee equal to 10% of investment profits. That's in addition to fees levied by the underlying hedge funds, which usually take 1% of assets plus 20% of profits. The total: 2% plus 30% of profits--compared with a flat 1.5% annually for the average equity fund. Roughly speaking, that means if a fund of hedge funds has a gross return of 30%, the net after fees would be just 19.2%. A similar mutual-fund investment would net 28.1%. In addition, the brokers' sales charge, or load, takes as much as 5% off the top. So your odds of beating a no-load mutual fund after fees are slim.
To be fair, the purpose of funds of hedge funds is to deliver returns in both down and up markets, not to trump mutual funds or a stock index. In that regard, they have succeeded in recent years, with the average fund of hedge funds delivering a net 31.9% three-year cumulative return vs. the S&P 500's 1.7%. But now that the recent bear market's worst days appear to be over, these funds are probably not a good investment. Over the long term they have lagged the S&P 500.
Investors looking to hedge their portfolios can find cheaper alternatives in retail mutual funds. Merger Fund, which has a $2,000 minimum investment, is up 44.2% cumulatively over the past three years, besting the average fund of funds. It uses the same low-risk merger-arbitrage strategy as many hedge funds for a fraction of the cost--a flat 1.34% of assets. The list of successful long-short funds, such as Calamos Market Neutral and Boston Partners Long-Short Equity, is growing (BW--Dec. 31). Such funds have profited handsomely in bear markets, and by allowing daily redemptions, they offer greater liquidity than hedge funds, which usually permit investors to cash out only quarterly or semi-annually.
Technically, some of the new hedge fund products don't have to put any net worth requirements on investors. By registering with the Securities Act of 1933, funds such as Oppenheimer Tremont Market Neutral have become public securities instead of private hedge funds, eliminating the need for accredited investors. "If you register under the 1933 Act, you can sell your fund to anybody you want," says Barry Barbash, a former director of the Securities & Exchange Commission. That's not happening yet, though. Tremont Advisers has set a net worth minimum of $1.5 million because of a rule forbidding funds from charging incentive fees to investors with less than that amount. Tremont Advisers declined to comment.
Maybe one day, if fees come down, funds of hedge funds will be worth considering for their diversification benefits. But right now, investors must pay too much for too little in return.
By Lewis Braham
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