Morningstar Advisor - Spring 2007 - 29

Where to Find Hedge-Like Strategies Funds of Hedge Funds Hedge-Like Mutual Funds Easy exposure to hedge-fund-type strategies Transparent Provide prospectuses Overseen by board of directors Passive Investments Risk diversification Exposure to many strategies and managers No performance fee Better liquidity than funds of funds + Cushion against blowup risk Access to good managers Looser investment restrictions Lower minimum investment requirements Shorter lockups Extra layer of fees Funds with low minimums tend to underperform Danger of overdiversification and muted returns Lack of nimbleness Lax approach to taxes – New, unproven niche Restricted in securities they can trade Limited leverage Lackluster returns Fees could be lower Lag bogy Poor representation opportunistic bets on the margins that may take several months to reallocate capital. Also, be on the lookout for funds that are overdiversified, which could mute returns. Indeed, the more funds that are in the mix, the lower the returns tend to be: Of the 820 funds of hedge funds in the Morningstar database, funds that include 25 or more distinct funds have underperformed peers that include fewer than 25 offerings. And adding managers appears to only marginally lower volatility. Fees, however, are the most serious drawback for the fund-of-funds investor. The typical fund charges an annual management fee of 1% and an incentive fee of 10%. Those are on top of the fees of the underlying funds, creating a series of embedded hurdles for the investor. Funds with the lowest minimums seem to be feeling the brunt of these costs the most. The typical multistrategy fund of hedge funds that carried a minimum investment requirement of $500,000 or less in the Morningstar database delivered a three-year annualized return of 7.3% through the end of 2006—a fairly pedestrian gain next to the overall average of 9% for funds with minimums above $500,000. Hidden expenses need to be taken seriously, too. After all, many hedge funds employ fasttrading strategies, which translate into rapid portfolio turnover. The result is the double whammy of high-trading costs and inherent tax inefficiency. A lax approach to taxes isn’t surprising, given that the compensation of most hedge-fund-managers is linked to pretax returns. More importantly, most hedge fund investors—qualified pension plans, charitable trusts, and endowments—don’t have to pay taxes and can afford to lock up their investment for many years. Taxes matter to the individual investor, of course, and a fund of funds’ tax efficiency should be a major factor when choosing and assembling investments. If there’s a large gap between pre- and post-tax returns, there’s a good chance the manager isn’t doing a plumb job of matching up tax-trading strategies. Also, be sure to ask whether a fund-of-funds manager’s performance fee is tied to post-tax, rather than pretax, returns over the benchmark. On the issues of costs and overdiversification, Carroll, the advisor from Colorado, says that with proper due diligence in fund selection, advisors can find a fund with a reasonable fee structure and without overlapping investment strategies. As for lack of nimbleness, he says that concern is not really relevant to the way he uses funds of hedge funds. “My interest is to reduce volatility and not necessarily increase performance, so nimbleness is the least of my concerns,” he says. “I want my overall hedge investment to have as little volatility as possible.” That means looking for a fund that is diversified across a broad range of strategies and has a history of solid performance. “When it comes right down to it,” he says, “I approach hedge fund investing with a high degree of skepticism. I’m careful about selecting portfolios for which I recommend a hedge fund.” Hedge-Like Mutual Funds: Transparent Alternative, but Pickings Are Slim Although they have limited use of leverage and are unable to trade certain derivatives and illiquid securities, mutual funds can still provide quick and easy access to some of the same risk factors that hedge funds do. They also have the benefit of being transparent. MorningstarAdvisor.com 29

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Morningstar Advisor - Spring 2007

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