Retail investors may be unprepared for a move into more aggressive strategies by hedge funds

November 17, 2013 9:05 pm

Playing to the cheap seats

By Stephen Foley

Retail investors may be unprepared for a move into more aggressive strategies by hedge funds

There were “booths as far as the eye can see”, says Henry Davis. Chicago’s McCormick Place conference centre bustled with activity in June, as asset managers and boutique investment houses competed for the attention of more than 1,000 financial advisers. These advisers are the gatekeepers to America’s retail investors, so anyone hawking a mutual fund wants to hawk it at Morningstar’s Investment Conference. And that was why Mr Davis was there for the first time.Carefully spoken and urbane, Mr Davis is managing director of Arden Asset Management, a “fund of hedge funds” business that used to cater only to the ultra-rich or to institutional investors. But it began wooing the masses last year when it launched a mutual fund. “The atmosphere is a big contrast from the small scale and intimate format you see in the traditional hedge fund world,” he says, recalling the maelstrom of marketing he witnessed in Chicago. “Lots of people were giving out teddy bears.”

The industry that once courted the Gulfstream crowd now has economy class in its sights. Hedge funds are repackaging their wares for a retail audience, and it is a crowded field. Traditional, mass-market fund managers are themselves clamouring to launch hedge fund-like products, hoping to recapture the glory days of high fees before low-cost index tracking and passive funds eroded margins.

The shifting landscape brings challenges for regulators who guard the safety of investors – doubly so since mutual fund investing has replaced corporate defined-benefit pensions as a central means of saving for retirement for many Americans.

The total amount of money in “alternative” mutual funds in the US alone rose 51 per cent in the first 10 months of this year, to $239bn, according to Morningstar. These “alts” account for just 2 per cent of mutual fund assets, but attracted about 20 per cent of the new money over the past year, as investors looked to diversify from bonds and equities.

Little wonder. When central banks finally tighten monetary policy, the increase in interest rates will lead inevitably to declines in bond prices. And after two savage bear markets in barely a decade, the sight of equity markets hitting record highs has alarmed more investors than it has excited. Hedge funds have lagged behind the stock market this year but their lower volatility is a selling point.

Advisers are urging hedge fund-like mutual funds on their retail clients, who would never be able to meet the minimum wealth thresholds – typically $1m, excluding their home – to qualify for investing in a proper hedge fund. Minimums were established by the Securities and Exchange Commission to prevent ordinary investors from taking on too much risk.

These alt funds must comply with SEC rules on mutual funds but they also offer trading tactics that were not typically available through traditional mutual funds – including the ability to short. The alt funds offer “long-short” equity or credit funds that can take both positive and negative bets on markets; macro funds that can jump in and out of countries, currencies and commodities; specialist funds that look for arbitrage opportunities in merger deals or pursue algorithm-driven quantitative investing; or multi-strategy funds that run a mix of all the above or build a “fund of funds” by giving money to multiple other hedge fund managers.

It is a bewildering array of choices. Regulators have not introduced any new rules to stop this diversification of mutual funds and there are real doubts whether retail investors will be well-served by the products on offer – if they even understand them.

“I think we are going to look back five or 10 years from now and some will have served investors well and some will have not,” says Larry Fink, chief executive of the world’s largest fund manager by assets, BlackRock. His firm identified selling alternatives to retail investors as an area of growth in its most recent quarterly earnings call with analysts.

“There is a drive among retail investors and the distribution houses that work with them to have a broader range of products,” he adds. “We should not put all alts into one giant category and think about them as all risky or all good for investors. You have got to look at the needs of the individual – their liquidity needs, their age – and for some, alts will be a larger component of their portfolio, for some not.”

BlackRock is not alone in expanding its hedge fund-like offerings for retail investors. Fidelity added alternatives to its menu this year. Franklin Templeton last year acquired K2 Advisors, a hedge fund group.

In an example of how the line between education and marketing can become blurry with financial products, AllianceBernstein this month announced a campaign to “demystify the array of liquid alternative strategies available”. Chris Bricker, its head of alternatives strategy, says that while hedge funds are sophisticated products, they are designed not to add risk to investors’ portfolios but to reduce it. Both corporate bonds and equities went into free fall during the financial crisis, so alternative assets designed to be uncorrelated could prove a cushion in future disasters – though some research suggests correlations are higher then often believed.

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The aim is to stop investors giving up and cashing out when markets are at rock bottom, as many are wont to do in traditional, volatile equity-focused portfolios, says Mr Bricker. “The risk diversification in traditional 60-40 equity-bond portfolios that had been sufficient for so long is not sufficient any longer; 2008 is still looming large in the rear-view mirror. Clients are not willing to accept that level of volatility and to stay the course.”

Mr Bricker adds that the regulations on mutual funds also help protect investors. But they might prevent them making hedge fund-like returns. One reason is that liquidity is a prerequisite for regulators, who will not allow ordinary investors to access funds unless they can be bought and sold on a daily basis, without the lock-ups and redemption delays that come with investing in traditional hedge funds. So alternatives managers have to exclude long-term trades that would be impossible to unwind quickly if investors demanded their money back in a hurry.

There are also limits on the amount of leverage a mutual fund can use: they cannot juice returns the way that traditional hedge funds can. On the other hand, mutual funds cannot charge performance fees – and competition means fees overall will be lower than in a traditional hedge fund. Still, alts will be more expensive than plain vanilla stock or bond funds. Even the cheapest funds charge almost 2 per cent per year, while investors can buy active equity funds for less than 1.5 per cent.

Michael Kelly, head of asset allocation at PineBridge Investments, is sceptical about the headlong rush into the so-called liquid alternatives.

“Quite often you are not getting the exact same strategy as in a traditional hedge fund, since you have to remove the less liquid portion and this has been over time the most return-enhancing portion,” he says. “And most alternatives have actually been very disappointing, including during the financial crisis. Returns from private equity have been below those of public equities and hedge funds have been below their policy benchmarks for six years running.”

Another risk: it may not be the hedge fund stars who expand into retail. “Oftentimes, it is the ‘B-plus and below’ crowd who have difficulty raising money who will go into the mutual fund world. Those hedge fund managers who can maintain more structures that are more favourable for them, overwhelmingly continue to do so,” Mr Kelly adds.

Arden Asset Management was the first “fund of funds” to pull serious hedge fund managers into its retail alternative mutual fund, including York Capital Management, Jana Partners and, recently, DE Shaw. Net fees are 2.3 per cent a year. That will sound high to a traditional mutual fund investor, but it is typical for a liquid alternative fund and may look a bargain to some, considering the managers may be charging their other clients the old hedge fund standard of 2 per cent a year plus a 20 per cent performance fee.

“It is a very delicate and time-consuming negotiation,” says Mr Davis. “There are certainly some managers who don’t want to have anything to do with this, they don’t need to do it, they don’t want to do it. But there are other managers who see a trend here, and understand that the single largest area of growth in the asset management industry is coming from individual investors.” Over the next five years, 80 per cent of net inflows into the asset management industry could come from retail investors, he adds.

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One large hedge fund firm that plunged into mutual funds long ago is AQR Capital. Founder Cliff Asness sees himself as the leader of a crusade for lower fees. “We do think that a lot of the active management world doesn’t want you to look behind the curtain,” he says. “They tell you it’s all so proprietary when in fact it’s the complete opposite.”

The dilemma for hedge fund managers is whether to seek a share of a global mutual fund industry that boasted $27tn of assets in the middle of this year – or to stick with the Gulfstream business model and hope that their institutional investors do not start to favour cheaper alternatives available in economy class.

One reason to make the switch is that shares in mutual fund managers trade on higher multiples than those of alternative asset managers, giving a valuation incentive to hedge fund firms that are thinking they might one day go public or sell out.

Mr Davis is sure the interest in alternatives will be higher at next year’s Morningstar conference, and that this is all to the good as long as advisers remain gatekeepers to these products. “What is not going to happen, and shouldn’t happen, is individual investors, who are not investment professionals, deciding to take a leap, and investing in something because they like the name of it,” he said. “I certainly hope it doesn’t happen.” But even some advisers may take convincing of the value of alternatives.

Edward Jones, the largest network of independent brokers in the US, is warning clients off. Kate Warne, its investment strategist, said that many alt funds did not substantially limit investors’ losses during the financial crisis, and they add a volatile new element to portfolios during the good times. “Markets go up more years than they go down, so why would you give up that upside in the hope of getting some protection on the downside, if in a crunch they may not do what you want them to do?” she said. “We are sceptical – and we are more sceptical the more alternative they get.”

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AQR Capital: Charting the path to lower fund fees

Cliff Asness likes to joke that he left Goldman Sachs when it was “still a partnership and a completely charitable institution”.

Of course, as a co-founder of the investment bank’s former in-house hedge fund, the Global Alpha Fund, Mr Asness knows how focused Goldman can be on making money, and he has made a bit for himself, too, striking out on his own in 1998.

He has done it, though, not by harvesting the usual 2 per cent annually and 20 per cent profit share of traditional hedge fund managers, but by pushing his firm, AQR Capital Management, into the potentially much bigger market of mutual funds.

His is a case study in how the rise of hedge fund-like mutual funds might drive down fees across the hedge fund industry.

It is not just retail investors who can buy mutual funds; institutions that currently invest directly in hedge funds may also be tempted.

From its headquarters in Greenwich, Connecticut, AQR runs 25 mutual funds with $13.2bn under management, including eight hedge fund-like “alternative investment funds”.

Morningstar rates these alternative funds expensive by mutual fund standards, but cheap compared to other hedge fund-like retail funds.

Mr Asness combines in one boisterous personality both a maths geek, who was a researcher under Nobel Prize-winning economist Eugene Fama, and a marketing genius, who argues that many hedge fund strategies are in fact quite simple, replicable, and therefore easily put into the cheaper wrapper of a mutual fund.

Mr Asness sees fees coming down further, as the scales fall from investors’ eyes and competition grows.

“Whether you will ever get rid of grossly overpaying for whoever got lucky in the past three years, I don’t know, but we are winning the intellectual argument,” he says.

“It’s an earlier chance to shape the argument because these alternative mutual funds are newer.”