First Allied program raises questions
about risk, conflicts.
San Diego-based independent broker-dealer First
Allied Securities is capitalizing on the hedge fund bonanza in a
different way than most of its rivals. The firm offering its reps the
opportunity to run their own hedge funds.
"From a broker-dealer point of view, we're willing to accept the fact that we have reps who are just as good as any mutual fund manager or hedge fund manager out there," says Mark Dransfield, First Allied's president. "Some firms have the attitude that 'You're just a rep.'"
He says his company is willing to place bigger bets on their advisors, giving them more credit for having industry knowledge and trying to understand their goals. And if running a hedge fund is one of those goals, Dransfield says First Allied is ready and willing to comply.
He adds First Allied's oversight processes make offering out hedge fund management less risky. "We require that we custody the assets at our clearing firm, and so thus we monitor their activity," Dransfield says.
Hedge funds are largely unregulated private investments that have seen assets under management within their various structures skyrocket in recent years. Hedge funds now manage about $1.3 trillion in assets, according to Hedge Fund Research in Chicago, double the amount from three years ago, and up from $1 trillion last year. Growth is continuing at about $50 billion per quarter, HFR says.
Hedge fund managers can reap big management fees on the assets they raise. A typical fee structure is 2% of the assets under management and 20% of the profits of the fund. Compare that to the paltry 1% the typical financial advisor charges, and you can easily see why getting into the hedge fund business is attractive to some.
To be sure, there are other ways to filet revenue from hedge funds as well. A high rate of turnover within the fund can produce commission revenue for the fund manager. Tricks of the trade such as this aren't lost on First Allied, however.
"It may be tempting for an advisor to generate activity to generate commissions," says Dransfield. "We recommend costs based on an institutional rate." Otherwise, he says, an advisor could just sit back and trade and get paid to generate income for himself.
It's smarmy scenarios such as this that has the financial services industry and regulators divided about hedge fund rulemaking. The Securities and Exchange Commission is conducting a series of closed-door meetings to figure out the best course of action for hedge fund regulation. Last year, rules requiring that hedge funds register with the SEC were quashed by a federal appeals court.
Meanwhile, members of Congress are investigating how to legislate the ways hedge fund operate, and are also calling on the Treasury Department to set new rules. Rep. Barney Frank, chairman of the House Financial Services Committee and freshly empowered with the Democrats' takeover of Congress, believes there is too much risk in letting hedge funds go unregulated.
"Given the increasing size of hedge funds and the growing role they are playing in the economy, it would be a grave error to allow the court decision denying any authority by the SEC to stand," says Frank. "At the very least Congress should give the SEC the power it has sought to require registration, and we should also be looking into whether any further SEC or regulatory authority regarding hedge funds is needed."
Because of all the hedge fund scrutiny, First Allied wouldn't let their reps comment for this story. "Our chief compliance officer recommends that we do not provide any advisors for comments on this subject, as hedge funds and other alternative investments are being heavily scrutinized these days," says Maureen Kilkenny, a First Allied spokesman.
However, if First Allied believes in its managers, doesn't have compliance issues and puts forth its hedge fund programs to investors, then why the ban on speaking with the press? "I think this is ridiculous," says Don Martin, a certified financial planner with Mayflower Capital in Los Altos, Calif. "Hedge funds lack transparency and produce an average small total return of 6.5%. There is too much risk a salesperson could get carried away being overenthusiastic about recommending a hedge fund that later crashed. How does a broker-dealer rep have time to run a hedge fund and also do the typical work of a rep? Seems like a marketing ploy that does not add value, but does add risk and fees."
Dransfield addresses the issue of conflicts of interest and mismanagement head-on: "There is an issue of fraud in hedge funds but it's not because of what's regulated or not," he says. Rather, it's a matter of proper monitoring and internal oversight, which he says First Allied brings to the table.
"Because of our monitoring and proper due diligence, we feel we've mitigated a lot of that risk, including conflicts of interest," he says.
Dransfield says that at least one of the hedge funds managed by a rep was begun at the request of the client. "They wanted performance-based fees," says Dransfield. "Our reps wanted to just participate in performance, so we structured a fee that way." He says First Allied also helped establish a high water mark for the fund so that if there is "no performance" the rep wouldn't get the fee. A high water mark sets a benchmark return for investors that, if not met, means no management fee is charged.
Of course, not all hedge funds have high-water marks. Many investments are big bets that take high risks to achieve great rates of return, and not all produce.
In a recent presentation about "red flags" in hedge fund investing, Don Phillips, managing director at Morningstar, said it's fees that crimp hedge fund returns, pushing performance of the hedge fund universe at large down to levels well below that of the mutual fund industry. "They simply charge too much," Phillips says.
Tantalizing returns, however, allow more and more vehicles to be established. According to industry estimates, there are 8,000 hedge funds and the total is growing fast.
Hedge funds are designed to appeal to wealthier investors, which also makes them attractive marketing tools for reps and, in turn, broker-dealers. But some financial advisors want to avoid controversy and prefer to stay away from them.
"It's smart for the B-D because that may attract brokers. But I would never use it. Anybody who thinks otherwise is a damn fool. Hedge funds are just a way for managers to charge more fees and escape regulation. They add no value, and the investors are getting fleeced by the hedge fund managers. Zero alpha is out there," says Jeffrey B. Broadhurst, a financial planner who manages his own firm in Lansdale, Pa.
On average, hedge funds returned 1% during the third quarter, and were up about 8% for all of 2006, Bank Net 360 reports. Compare that with the S&P 500 Index, which is up more than 14% for the year, and you have to really question much of the sanity behind investing in hedge funds.
But First Allied isn't so much concerned about high rates of returns as it is with pleasing its constituency. And that constituency consists of financial advisors seeking out new and innovative products and programs in order to solicit new clients.
First Allied is claiming vaunted space in the product marketplace, especially the wealth management arena. It claims to have relationships with 44 of the wealthiest families on the Forbes list. And to appeal to them and other megamillionaires, First Allied packages a late-stage-financing private equity product for its representatives to sell to clients.
"If you ask someone with $50 million how they made their money, they either inherited it or they took their company public. So when our rep is talking to someone with $50 million and they talk private equity, their ears perk up; they know that's how they made their millions," Dransfield says. That translates into a selling point, he explains.
Although Dransfield believes that First Allied has a place in hedge fund management, others aren't so sure it's a place for most broker-dealer reps or other financial planners. "When you look at some of the brilliant hedge fund managers out there, and then you take a look at the average rep, I'm skeptical," says Don Patrick, managing director of Integrated Financial, an independent financial planning firm in Atlanta. "Everybody and his brother is turning into a hedge fund manager."