The three groups Stanasolovich is using are Rydex, Man Investments and Undiscovered Managers, which has a $40,000 minimum. Like the institutional investors described by Palmer, he is looking for noncorrelated assets. "But so much stuff has very short track records, and you devise portfolios of mutual funds with long track records of uncorrelated returns," he says.
Another problem advisors cite about hedge funds' performance statistics is so-called survivorship bias. Many funds that are launched flounder and ultimately fail, and performance results for a particular class or strategy are overweighted with the winners, which have outperformed their peers. Good luck to any financial advisor trying to get into those funds. "The best managers don't want any more money because they want to remain nimble and earn their income off of performance appreciation," explains one fund of funds executive. "The mediocre ones want to raise big bucks and get paid off the performance fees."
How extensively are advisors using hedge funds? Fred Whaley, managing director and head of alternative investments at Raymond James Financial Services in St. Petersburg, Fla., reports that about 18% of the firm's 5,000 or so reps are using them.
"We look at hedge funds that reduce volatility and serve as a financial planning tool that's part of the asset allocation model, not ones that use leverage and concentration to generate returns," Whaley says.
Typically, he seeks funds of funds that produce overall equity-like returns with lower volatility. That means the fund of funds will frequently have annual returns of 8% to 12% but volatility of 4% to 6% rather than the 12% to 17% volatility that individual funds within the fund of funds might display. Whaley also says funds with a seven-year track record give him a chance to evaluate their performance in almost every kind of environment imaginable, although he has to look behind the numbers to see how they got their returns.
For many advisors, navigating their way through the hedge fund maze can be a frustrating, time-consuming process. The hedge fund universe encompasses a broad array of different strategies ranging from distressed securities to convertible arbitrage to global macro.
By far the dominant strategy, however, is long/short equity investing. Expertise and performance vary widely. "Most have a long or a short bias because if you try to be completely market neutral, you can lose your caboose to transaction costs," explains one sponsor of a fund of funds. "The real value-added comes on the short side. Many managers who come from a long-only background like mutual funds tend to be very poor short sellers. So they will use index options or futures as a substitute for substantive short positions."
On average, long/short equity hedge funds appreciated about 20% in 2003, compared with 28.3% for the Standard & Poor's 500 Index, according to Jeff Joseph, managing director of the alternative investments group at Rydex Capital Partners in Chicago. "It's a strong validation of the space," he argues. "They [long/short equity hedge funds] did it with less risk than the S&P 500."
One new trend that emerged in 2003 was the advent of hedge-fund index funds. This group raised more than $1 billion last year. Among those developing hedge-fund index funds were Rydex, Morgan Stanley, and CSFB/Tremont. Dow Jones Indexes is reportedly developing its own benchmark.
"Hedge fund indices offer more protection than most fund of funds," Joseph says. Indeed, the odds of having a hedge fund implode upon advisors' clients is reduced by investing in an index. However, if discombobulations affect the majority of hedge funds devoted to a single strategy, like global macro, it probably will be reflected in the index's overall return.