Who Needs A Hedge Fund Anyway?

Returns are meager or negative, capital flows are slowing and hedge funds appear to be folding at a record rate; so monied investors might be prompted to ask ... who needs a hedge fund anyway? 

“Institutions have taken over the hedge fund space," says Morningstar analyst Nadia Van Dalen, adding they are intrinsically better able to identify the best-performing funds and then pour money into them. “The high net worth investor is at a worse disadvantage now [than in the past].”

So much for letting the individual investor play with the Big Boys.

“[High net worth] retail investors shouldn't be in hedge funds,” says Adam Patti, CEO of IndexIQ, citing “exorbitant fees, little transparency" and lock-up periods.

Since Patti’s IndexIQ recently launched what it calls the “first no-load open-end mutual fund designed to replicate hedge fund performance”, he may not be the most disinterested observer. But his qualified assessment is shared by enough others. 

It's part of what might be called a modest rethinking to the golden age of hedge funds. In July, the industry posted its worst monthly performance -- a loss of 3.07 percent -- since Morningstar has been keeping data. June was also negative.

Performance In The Spotlight

First-half performance, according to another tracker, Hedge Fund Research, was negative for only the second time in almost two decades while inflows slowed dramatically.

"Delivering consistently good risk adjusted returns that also maintain a very low correlation to stock and bond markets is not an easy thing to do,” former Morgan Stanley CFO-turned hedge fund manager Phillip Duff told CNBC in a rare TV interview in late July. (Watch the complete interview here.)

Based on the performance of the Henessee Hedge Fund indices, the average hedge fund has outperformed the Dow Industrials in seven of the past ten years,

Average, however, pretty much describes the performance of most of the 8500 hedge funds and funds of funds tracked by Morningstar.

“Hedge fund managers make themselves out to be alpha managers, but what you’re getting in the average hedge fund is beta, what the market yields,” says Van Dalen, who’s covered the industry since 2005. “Alpha managers are few and far between.”

Duff, who now runs Duff Capital Advisors, has a different perspective, which suggests a similar assessment. "The demand for hedge funds still continues to well exceed the supply of quality management.”

Van Dalen attributes some of the “mediocrity” to the “proliferation” of funds in an industry whose assets almost doubled in the past three years and are now estimated at $2-plus trillion. 

“Anyone with a good idea and a record was getting hired. It’s going through a reality check," says veteran money manager Jim Awad, vice-chairman of WP Stewart Asset Management. "You had a terrific risk-seeking environment.”

Duff expects the shakeout in the "ultimate Darwinian business” to produce more fund failures than launches this year -- another first.

“The big will get bigger in this low-risk tolerance, high-volatility environment,” adds Ken Heinz, president of Hedge Fund Research. “The bar is significantly higher now to launch a fund.”

HFR's monthly index showed a 2.35-percent decline for July.

Looking Under The Hood

The reality is many hedge funds aren't really hedge funds, except that they charge a 2% management fee and 20% performance fee.

“Hedge funds are now stock-picking funds,” says Patti.

No wonder that funds with equity strategies were not only among those with the poorest returns but they also suffered big outflows in the first five months of 2008, according to Morningstar.

But there's also been a herd mentality, which is has not been good for returns.

The long commodities, short financials strategy has blown up on more than a few funds recently, which helps explain the bad returns of July.

“Only a certain number of hedge funds can profit from an environment,” says Van Dalen, citing the debt-leverage play of recent years.

And only a certain number of investors can profit from it -- and that’s less and likely to be Jane and Joe Dom Perignon, retail investors with fat portfolios.

“High net worth investors don't get access to alpha managers,” says Van Dalen. "They can't pay the price of entry," which can reach $100 million.

Such investors are "probably not getting the top, top funds that are worth their fees,” adds Patti.

That may help explain the asset flows and the shrinking numbers of funds. Morningstar data for the first half of this year shows equity strategies suffered $14.6 billion in outflows in suffering the worst returns.

"Right now, investor risk tolerance across a lot of asset classes is at a very low level, “ says Heinz. “That’s reflected in number of funds being launched and capital going into funds.”

Awad says some investors jumped into hedge funds because conventional asset classes weren’t delivering favorable returns, looking for non-market correlated investments.

“Some people who didn't understanding what they bought are leaving, “ adds Awad.

“It looks like they're acting like mutual fund investors and performance chasing,” says Van Dalen.

Leave It To The Big Boys

Investing in hedge funds often conjures up Wall Street’s version of the old school yard expression “playing with the big boys.” Indeed. In this case, we're talking institutional investors, such as pension funds and brokerage firms –- JPMorgan Chase, Merrill Lynch, Bear Stearns, which bought into the business to one extent or another and at one time or another, and then steered their clients into it.

Others don't see a disservice to or disadvantage for retail investors. "That's not my sense," says Darrell Aviss, managing director at SwissGuard International, a Swiss-based financial consultant that caters to wealthy clients. "The opportunity is in the small to medium funds."

Differences aside, virtually all agree the slowdown in capital flows is temporary. In particular, the bigger, long-term trend will continue for institutional investors, which his Patti’s new fund happens to be targeting.

"It’s a blip related to what's going on in the economy," says Aviss. "The best example is the Bear Stearns funds."