Why the wealthy are still sticking with hedge funds

Almost half of Leslie Quick’s personal portfolio is dedicated to hedge funds, a position he’s increased this year even as the lightly regulated asset pools have returned less than 4 percent. “I think we’re coming into a period where stock picking will be richly rewarded after returns that were anemic,” said Quick, 58, a founding partner of Morristown, New Jersey-based Massey, Quick & Co. LLC, an investment advisory firm with about $3 billion in assets under management. “When the volatility really started about a month ago, I walked away from the office with a real sense of calm.” Wealthy investors like Quick are staying with hedge funds for protection from the market turmoil that sent the Standard & Poor’s 500 Index up or down by at least 4 percent for four consecutive days last month, said David Donabedian, chief investment officer of Atlanta-based Atlantic Trust, the wealth management unit of Invesco Ltd. Almost 90 percent of 151 single-family office directors surveyed in the first quarter by Rothstein Kass, an accounting and advisory firm in Roseland, New Jersey, said they’re likely to put additional money in hedge funds this year. About 85 percent of the single-family offices surveyed in the study were already invested in hedge funds. New money put into hedge funds by institutional and individual investors totaled about $32 billion in the first quarter of 2011 and almost $30 billion in the second quarter, making it the strongest half year since 2007, according to Chicago-based Hedge Fund Research Inc. ‘Good Middle Ground’ “With the high volatility in the equity market and low income to be earned in the high quality fixed-income market, a lot of investors view hedge funds as good middle ground,” said Donabedian, whose firm oversees $17 billion in assets and builds customized portfolios of single-strategy hedge funds for clients. Hedge funds gained 3.4 percent this year through August, according to the Bloomberg aggregate hedge-fund index. That compares with a 3 percent decline for the S&P 500 during the same time period. The main Bloomberg hedge-fund index is weighted by market capitalization and tracks 2,804 funds, 1,238 of which have reported returns for August. Wealthy investors who put money in hedge funds face high fees, usually a 2 percent management fee and a 20 percent performance fee, and a lack of transparency and liquidity, said Stephen Horan, head of private wealth management for the CFA Institute in Charlottesville, Virginia. Pro’s Game “This last subscription period was one of our best months ever,” said Uri Landesman, president of New York-based Platinum Partners, which has about $1 billion in assets. Eighty percent of those assets come from high-net-worth investors and family offices, Landesman said. “When the market is moving uni-directionally, people don’t feel like they need to bring in managers of our caliber who charge our fees,” said Landesman. “With significant doubts about where the markets are going and volatility being introduced, investors correctly are saying this is a game for the pros.” Wealthy investors are attracted to hedge funds because they generally have low correlation to the market and can enhance the risk-adjusted returns of portfolios, said Mallory Horejs, alternative investments analyst at Morningstar Inc. in Chicago. “Effective hedging can enable you to remain invested at a higher level, but enable you to sleep at night because you won’t get whipsawed by the volatility and market corrections,” said Michael Tiedemann, chief investment officer of New York-based Tiedemann Wealth Management, whose average client has about $65 million in investable assets and advises $6.5 billion in total. Liquidity Issues Macro events such as the European sovereign debt crisis have made markets more volatile, which makes hedge funds important for high-net-worth investors to include in their portfolios because of their diversification benefits, said Darrell Cronk, regional chief investment officer in the New York office of Wells Fargo Private Bank, which manages $210 billion in assets. “Alternative assets are more critical now than ever,” Cronk said. Wealthy investors are putting money in hedge funds even though they’re still scarred from liquidity issues during the financial crisis, according to Atlantic Trust’s Donabedian, who’s based in Baltimore. Some hedge-fund managers such as Philip Falcone of Harbinger Capital Partners LLC declined to give investors all of their money back in 2008 because that would have meant divesting hard-to-sell assets at bargain prices. Harbinger has yet to sell some of those positions almost three years later. ‘In the Doghouse’ “You have to ask, ‘Why is new money flowing into an asset class that was in the doghouse?’” said David Frame, head of alternative assets at J.P. Morgan Private Bank in New York. In 2008, hedge funds declined 19 percent compared with the S&P 500’s 38 percent drop, according to Bloomberg data. Hedge-fund returns were 9 percent in 2009 and 8 percent in 2010, Bloomberg data show. Almost a quarter of members of a peer investment group surveyed said the investment that didn’t work out as they had expected was hedge funds, according to a study in the first quarter. The group, Tiger 21, has about 180 members, with collective assets of $15 billion. Quick, the hedge-fund investor in New Jersey, is a member of Tiger 21. The majority of hedge-fund assets were traditionally held by ultra-wealthy individual investors before being eclipsed by institutions, such as pension funds and endowments. Institutional investors made up 61 percent of hedge-fund assets as of the first quarter of 2011 compared with 44 percent in 2008, according to London-based research firm Preqin Ltd. $1 Million Threshold Individuals who want to invest in hedge funds must generally have at least $1 million in net worth under the Securities and Exchange Commission’s rules. Some hedge funds may require individual investors to have at least $5 million in investable assets. Quick said he and his partners at Massey, Quick & Co. have invested more than $100 million of their own money in hedge funds. When selecting hedge funds, he looks for those that have low leverage, less than $3 billion in assets, and whose managers have a significant amount of their own money invested in the fund, he said. Cynical Investors Not all investors are comfortable putting more money in hedge funds. Alan Zafran, co-founder of Los Angeles-based Luminous Capital investment advisory firm, which manages $4.6 billion for about 300 families, said he’s seeing some of his clients’ interest in hedge funds wane after reaching a peak about four months ago. “They hire hedge-fund managers under the premise that sophisticated individuals can navigate turbulent markets, but ironically, when markets become turbulent, investors want to have a greater sense of control over the process,” Zafran said. Investors who continue to put money in hedge funds have become more cynical and changed the way they approach them following the 2008 rout and disappearance of 1,471 funds, said Tiedemann, who’s also chief executive officer of Tiedemann Investment Group, which is a multimanager hedge-fund platform. Funds with less than $1.5 billion have started to become more attractive to individual investors since some larger funds have struggled with lackluster returns, and the smaller funds tend to be more nimble, which enables them to take advantage of the current environment, Tiedemann said. Hedge funds managing from $500 million to $1 billion of assets brought in $4.7 billion in the first quarter and those with less than $5 billion increased assets overall by $16.3 billion in the first quarter, according to Hedge Fund Research. Smaller Funds “Nirvana is a fund that has about $200 million to $1 billion, at least a three-year audited track record, and is under the umbrella of a strong, stable operation,” Luminous’s Zafran said. There will be a “mass exodus” from young upstart firms that lose as much or more than the equity market if the market continues to struggle, said Peter Rup, chief investment officer of New York-based Artemis Wealth Advisors LLC, who has increased his clients’ hedge-fund allocation to as much as 35 percent this year from 20 percent. In terms of the preferred hedge-fund strategies among individual investors, once all funds’ returns for August are published, hedge-fund managers’ different approaches will be tested and investors will gravitate to those that stand apart, Tiedemann said. Frustration With Stocks Wealthy investors who can afford to are more likely to put money directly in hedge funds instead of going through fund of funds since some fund of funds were tainted by scandal related to Bernard L. Madoff, poor performance and a high rate of failure during the financial crisis, said Stephen Brown, a finance professor at New York University’s Stern School of Business. Fund of funds lost 21 percent in 2008, according to Hedge Fund Research Inc.’s Fund of Funds Composite Index. Outflows from fund of funds reporting to Morningstar’s Hedge Fund database were $165 million in June compared with inflows of $7.2 billion in June 2007, Morningstar data show. Investors who have less than $5 million to invest in hedge funds may still be best served by going through fund of funds to mitigate risk, said Donabedian of Atlantic Trust. Frame of J.P. Morgan Private Bank said liquidity is more of a concern now for clients than it was pre-crisis and allocation to alternative assets is about a third because “our clients need to be able to access money for certain life events.” The hedge-fund industry has responded to that issue and become less levered and more likely to put money in underlying investments that are easier to buy and sell, Frame said. Despite the concerns, the frustration with returns of very liquid investments, such as stocks, will continue to result in more interest in hedge funds, according to Frame. “In 2008, people were disappointed with hedge funds, but the people who only had equities wished they had been in hedge funds,” said Frame. “They’re the ones who are changing.” Bloomberg