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Chasing bad performance: Why investors can't get enough of those increasingly lame hedge funds

Most assets are institutional but there's a trillion dollars of baby boomer assets ripe for the plucking by RIAs who can generate returns sans the highway robbery fees

Tuesday, April 28, 2015 – 7:46 PM by Guest Columnist Rob Isbitts
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Rob Isbitts: That money should have a target on its back, and we RIAs as an industry should be managing it.

Brooke’s Note: Hedge funds are not bad per se. It’s just that their fees are high and so many hedge funds have such lousy historic returns relative to, say, mutual funds or ETFs. Still, hedge funds can justify some premium based on their hedging. They are, in essence, an insured portfolio. What Rob Isbitts explains here is that the insurance premiums are just way too high in most cases. It would be one thing if cheap insurance weren’t available on the market. It is, though it demands some do-it-yourself perspective. See: The top 10 alternatives to alternative investments. Rob believes that RIAs are more than capable in 2015 of utilizing any number of means of hedging markets without outsourcing to a hedge fund manager — especially as the bull market roars on.

Hedge fund assets are expected to rise again in 2015 — this despite a recent Deutsche Bank survey indicating that two-thirds of surveyed investors said returns did not meet their expectations in 2014.

One year is not really a sufficient time period to judge an investment strategy. Three years or more seems more reasonable. However, this is really a repeat performance. You have to wonder what it is about the hedge fund industry that has allowed it to amass over $3 trillion in assets, more than doubling since the financial crisis, according to a recent Reuters article discussing the Deutsche Bank study.

At some point in the past, the likely answer was strong returns in a wide variety of market conditions.

But more recently, it may have more to do with what the RIA marketplace has not done. I have a strong sense that hedge funds’ continued success at the “box office” (i.e. revenue generated from assets gathered) is a sign that the RIA business has not effectively communicated the virtues of what I call “Hedged Investing” — investment strategies that can play both offense and defense well, and do so without the opaque and expensive wrapper of a hedge fund partnership. Those partnerships have caused so much pain for investors during and since the Great Recession. See: How capture ratios can help you prepare for the next downturn.

After all, for hedge fund investors, what you don’t know might hurt you. See: How the alternative investments category got bastardized and why that’s a shame.

Trillion with a T

It should be noted that about two-thirds of hedge fund assets belong to institutional investors, a clientele that is often not within the RIA wheelhouse. But what about the other one-third of hedge fund assets held by non-institutional investors? That’s a trillion dollars! That money should have a target on its back, and we RIAs as an industry should be managing it. All we need is a way forward. Here are some things to consider in approaching this $1 trillion opportunity with retail investors who own hedge funds.

Hedging is a simple concept, but hedge funds make it too complex for retail clients. Leverage, “swaptions,” CDOs, “side pockets” and other shenanigans (technical term there) make investors forget about what they are really aiming for when they invest in a hedge fund: preservation and growth of capital over a reasonable time frame (I generally consider three years to be reasonable). See: The truth about hedge fund risk.

Hedged investing: Hedge funds need not apply

However, there are four additional considerations I can identify which could be part of hedge fund investing, are not, and can be features of hedged investing for the non-institutional investor.

1. Income Institutions often seek out hedge funds as a bond alternative. I strongly believe that rates will either rise or stay relatively flat over the next decade. If I am right, then we have to approach this like a conservative football coach who likes to run the ball instead of passing it. As the old expression goes, when you pass there are three things that can go wrong, and two of them (incomplete pass, interception) are bad. See: Winter winds hitting bond investors, China takes a pass, alternatives posted strong gains: Morningstar data.

Similarly, hedged investing can be the answer for the glut of baby boomer retirees. The formula is simple: dividend-oriented stocks on the long side and inverse ETFs to guard against major market drops. That combination is the basis for a strategy I have used since I started my firm, and it has become our flagship approach for these investors. I see no reason why other RIAs cannot pursue this approach as an alternative for clients who perceive their hedge fund investments as their “safe” money to supplant or supplement their bond portfolios. See: 'Paradigm shift’ in 401(k) flows opens the DOL door for annuities in 401(k) plans and RIAs are split.

2. Liquidity Pardon the pun, but the use of individual stocks versus hedge funds flows like a cool stream of water into the second key reason RIAs should develop alternative strategies to hedge funds. As I see it, the stock market is far more liquid than many markets that hedge funds traffic in. In addition, hedge funds do not let you out when you want out. You can get out in full or in part whenever the fund’s partnership agreement says you can. Who needs this type of pre-nup for their hard-earned assets? Not your clients! See: The top 10 alternatives to alternative investments.

3 Transparency Hedge funds do not play by the same rules as we do when we set up a client account at a well known custodian and manage it right in front of the client. Hedge funds can hide a lot. And while there are certainly some excellent citizens in the hedge fund business, the lack of regulation and freedom granted to hedge fund operators is something that should scare the bejesus out of some of your clients. See: How the Winklevoss twins disrupted a big NYC hedgie event and distracted from the poor job most hedge funds are doing for clients.

4 Investment Cost I am not sure I even need to write anything here. We all know that hedge funds are expensive. The only question is how expensive they are compared to what we know about their expenses. The once standard 2% of assets plus 20% of profits gouged by hedge funds is dropping gradually. The Economist reported in late 2013 that the old 2 and 20 is now down to 1.4% and 17% of profits, on average. But with limited regulation, potentially layers of parties and counter-parties and complex investment techniques, do you and your client really know how much they are not getting?

Cry for help

I have found that retiring and retired baby boomers really appreciate that good old-fashioned ability to see where their money is and count it any time they want. Hedge fund partnerships do not offer this. And we know from the financial crisis that what goes on behind the curtain of some of them is not something investors would willingly commit to if they knew.

I think some of that $1 trillion in assets we are talking about are simply crying for help — assets that are currently allocated in hedge funds that feels right to investors because of their perceived panache, exclusivity or differentiation from traditional investments — or all of the above.

But it does not have to be that way. Advisors just need to put some thought into how to construct their own version of what hedge funds do.

Liquid alternatives: Often too wet for RIA clients

The RIA business has jumped all over the “liquid alternative” concept over the past decade. As one of the first managers of an alternative mutual fund, it is impressive to see how much that idea has expanded within the RIA space. But I can’t help but see the same pattern emerging here as in the hedge fund business: instead of keeping portfolio construction, liquidity and transparency as straightforward as possible, fund companies in the liquid alts space are often removing just the hedge fund wrapper, but retaining the risks of underlying asset transparency and liquidity — i.e. do you really know and understand what you own, and when it hits the fan will your fund manager be able to prevent your NAV from plunging? See: A more liquid alternative to alternative investments catches on.

Alternative mutual funds can still use leverage but it is capped at 33% of net asset value. But fund managers can get around this by using certain types of derivative securities. As for liquidity, they need to keep 85% of their assets in securities that can be traded within seven days.

The other 15% that can cause trouble. Remember, these funds can be purchased by many clients who would otherwise fall below the accredited investor rules that govern hedge funds. The chances are pretty good that right now there is a lot of money in liquid alt funds that would not be there if the investor knew some of these things. Let’s see what happens next time there is a run on such funds and they need to create liquidity in a day. See: A cottage industry of hedge funds-to-RIAs is springing up but so far the mutual fund industry looks like the big winner.

For investors, liquid alts also pose the “who am I in the room with?” problem. I suspect that much of the flows into these products have come from inexperienced investors who may not really understand what they own. When markets get temporarily unfriendly, will they all jump out of the pool while you want to stay in? That works against you. See: This Atlanta roll-up start-up plans to reach $1 billion right quick by using hedge fund cash to execute a Schwab template.

Under the wrapper

And as for costs, according to a recent Wall Street Journal article Morningstar, Inc. has the average alternative mutual fund expense ratio at 1.9%, with some funds at over 4%. Remember, those expense ratios do not even include trading costs. So, with the hedge fund wrapper removed, we can see the costs clearly — but they are still way too high for an investing public that is distracted by the allure of low-cost index funds.

An investment concept becomes so much of a one-way trade that many continue to invest their hard-earned money in something, well after it has outlived its usefulness. Another current example of this is indexed investing, particularly when done under the guise of Modern Portfolio Theory. I am part of a shrinking minority that still believes that active management should be a critical part of an investment plan, particularly for those with larger portfolios and/or an investment time horizon under 20 years. See: What one financial advisor discovered after plunking down $12 for Tony Robbins’ 'Money’ manifesto.

But active management can be simple, and it is my strong belief that it must be simple in order for the RIA business to distinguish itself from the many hucksters in the mutual fund and brokerage businesses. See: 5 ways for incumbent advisors to get — and keep — their clients’ vote of confidence.

Danger ahead

RIAs (or more appropriately stated, IARs, the people who work at RIA firms) are unique in that we are investment-centric in our daily work. If you simply pass off that daily responsibility to fund companies with new, sexy liquid alternative products, or go on a manager search for a hedge fund or fund of funds (oh, talk about a mountain of fees!), it may work out — or you may just blow the one advantage you had over your competitors. See: Why target date funds fail in the one area they’re supposed to succeed — downside protection.

Perhaps I am just worrying too much. But I cannot help feeling that there is another set of hedge fund disasters out there. But then again, when has leverage, pursuit of “safe” returns at any cost, extreme use of complex financial instruments and fund managers operating in darkness behind figuratively closed doors ever made life miserable for RIAs and their clients?

Rob Isbitts is the co-founder of Hedgedinvesting.com, an investment research and portfolio management portal for financial advisors. He is a thought leader in the area of “hedged investing”...but he is not a hedge fund manager. Over the past three decades, Rob has managed daily-liquid portfolios through diverse market conditions. He has created several investment strategies, including the Sungarden Hedged Dividend portfolio, an alternative approach to the pursuit of income, preservation and long-term growth. Rob has managed mutual funds and authored two books. He blogs regularly at Hedgedinvesting.com, and can be followed on Twitter @robisbitts.

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