Posted by on Dec 13, 2013 in Blog, Columns |

By Jason Zweig | 7:12 pm ET  Dec. 10, 2013

Five years later, the most ironic part of Bernard Madoff’s legacy is clear: After his Ponzi scheme made hedge funds seem scary, especially to individual investors, the industry got busy making them seem safe enough for everybody.

 So-called liquid alternative funds have become the hottest thing in the mutual-fund business. These portfolios—essentially hedge funds with a longer, trendier name—employ such strategies as betting on mergers, wagering that stocks will go down as well as up, and using derivatives like futures and options. Their assets are up 33% this year to more than $244 billion, with nearly $53 billion flowing in through Sept. 30, according to Strategic Insight, a fund-industry research firm.

Since 1940, managers of mutual funds have been required to register with the Securities and Exchange Commission. Partly as a response to the Madoff scandal, the Dodd-Frank financial-regulation law, enacted in 2010, generally requires all investment firms managing at least $100 million to register with the SEC.

As a result, many managers who previously ran only hedge funds became eligible to run mutual funds for the first time. At the same time, millions of investors, still smarting from their losses on stocks and bonds during the financial crisis, were looking for new ways to diversify.

Hedge-fund managers now must disclose details about fees, strategies and operations that individual investors often couldn’t get under previous regulations. That has boosted the sales pitch for alternative funds by introducing the word “transparency.”

At heart, hedge funds seek to provide returns comparable to those of stocks, but with lower risk and “correlation,” or direct linkage to the ups and downs of the stock market. That served their investors well in 2008, when the HFRI Fund Weighted Composite Index, a broad measure of hedge-fund returns, lost just 19% compared with the ghastly 37% loss of the S&P 500.

Unfortunately, while some hedge funds have done well recently, most haven’t. The same HFRI index has returned 7.7% annually over the past five years; the S&P 500 is up nearly 18% annually.

Big investors such as pension funds and university endowments, annoyed by years of pallid hedge-fund returns—and their own dashed hopes of huge gains—are demanding lower annual expenses. Meanwhile, many hedge funds aren’t generating performance high enough for their managers to earn incentive fees, the cut they take of profits above a certain threshold.

So the 1.5% or so that hedge-fund managers can earn annually to run a liquid alternative mutual fund looks a lot more attractive than it used to—especially because mutual funds are the flypaper of the money-management business. Whatever lands there stays there. That assures a stream of fees for years to come, even when the managers aren’t doing well enough to earn an incentive fee elsewhere.

But going down-market with mutual funds while staying upmarket with hedge funds won’t be easy. “One of the big potential problems is cannibalization,” says Brian Daly, a lawyer at Schulte Roth & Zabel in New York who represents fund managers. “Can you design a [mutual-fund] product that’s different enough to run alongside an existing hedge fund and keep both constituencies happy?”

At major brokerage firms in the U.S., says Robert Martorana, an analyst with Strategic Insight, clients have some 3% of total assets in hedge-fund-like assets. But most leading firms, he says, are pushing their brokers to raise alternative allocations to 15% or 20% for wealthier clients with moderate tolerance for risk.

That push, reckons Mr. Martorana, could drive assets in liquid-alternative funds to $550 billion by 2018—roughly one-fourth the total size of the hedge-fund industry today.

But if alternatives get that big, will they be alternative anymore? And will individual investors and their brokers or advisers understand that most of the time these funds are supposed to be boring?

Professional investors already struggle to find good hedge funds that aren’t already too big to stay good; as that former hedge-fund manager Warren Buffett likes to say, size is the enemy of returns.

“Is there enough talent to go around?” asks Elizabeth Hilpman, chief investment officer at Barlow Partners, a firm in New York that invests approximately $1 billion in hedge funds on behalf of institutions. She pauses, then answers: “I don’t really know.”

Investors suffer from many mental shortcomings, but amnesia is almost certainly the most dangerous. Those who can’t remember the main lesson from the Madoff debacle—low risk and high return never stay wrapped in the same package for very long—are condemned to repeat it.


Source: The Wall Street Journal