Some advisors are using hedge funds to minimize risk, not boost returns.
One might think the end of a three-year bear market would have short-circuited the hedge-fund boom-some call it bubble-in 2003. But it didn't happen.
Interest in these vehicles among financial advisors continues to vary widely, but more advisors are using them and not for the reasons observers might think.
To put it bluntly, they aren't seeking to hit home runs for clients. Take Tim Kochis of Kochis Fitz, a San Francisco advisory firm with about $900 million in assets under management. The firm invests about 15% of clients' assets in hedge funds, or fund of funds. When it comes to ranking them on the risk spectrum, Kochis considers the funds his firm uses less risky than long-only equities, but adds that they also offer lower returns.
The hedge fund managers he uses are hardly the gunslinging, shoot-the-lights-out style investors lionized in the popular media. Most seek returns of 6% to 12% a year, 0.5% to 1% a month. Absolute return hedge fund of funds can be viewed as "a good alternative to fixed-income investments," Kochis explains. "We want predictable returns, and a hedge fund that gets 70% one year is obviously unpredictable."
Funds that are more consistent and less spectacular just may fit the bill. "The fund of funds we use might have two negative months in four years, and the negative [return] months are fairly small and easy to recover from," he adds. "On an efficient frontier, absolute return fund of funds would be slightly above the curve. If you put them into an optimizer without any constraints, it would say go 100% absolute return hedge funds."
But like most advisors, Kochis has long recognized that an unconstrained optimizer is a disaster waiting to happen. He also acknowledges that hedge funds possess several drawbacks. The biggest probably is their tax inefficiency, which is why Kochis prefers placing them in qualified accounts. Illiquidity comes in a close second. A third reason, Kochis says, is that "we don't expect them to be as high a return vehicle as long-only equities."
Finally, clients who have bought into the firm's mantra often note that absolute return strategies clash with many basic tenets of financial planning, and represent a departure from traditional advice about maintaining a stable asset allocation and avoiding market timing. "It's a fair question," Kochis concedes. "We say, 'This is a hedge.' The funds are selected so they can get positive returns in down markets, and they've been doing it."
The strategy that Kochis is employing is being embraced increasingly by giant institutional investors like pension funds and endowments. They are reasoning that in an era when many expect to earn mid-single-digit returns from equities and bonds, the additional flexibility of hedge funds may permit these vehicles to generate high-single-digit returns. Kochis still believes that in the long term long-only equity will outperform hedge funds and so has allocated a higher portion of clients' assets to that arena.
Relatively conservative institutional investors are whistling the same tune as Kochis. "Endowments and foundations have embraced hedge fund managers," says Charles Palmer, a performance analytics consultant to large institutions at CPSoftware in La Quinta, Calif. "What they are trying to do is mix different assets that are not highly correlated. It's understandable why absolute returns are an attractive alternative, and they are a nice pitch for salesmen, but are people just chasing a new strategy after three lousy years?"
Yet most advisors are taking a far more cautious approach than is Kochis. Lou Stanasolovich, CEO of Legend Financial Advisors in Pittsburgh, is using several fund of funds, but only for a handful of clients with more $2 million in assets. No more than 5% of clients' portfolios are allocated to hedge funds, which contrasts with Kochis' maximum limit of 25%.