Accredited high-net-worth individuals haven't generally been eager to jump into hedge funds-and it's hard to blame them.
Many have never learned much about these vehicles, which have a limited ability to market themselves, and don't know where to begin, says Jack Killion, a general partner at Eagle Rock Partners LLC, a fund of hedge funds manager in Long Valley, N.J. Financial advisors often don't know a lot about them either, or are restricted by their firms from recommending them.
Nor are the industry's well-publicized scandals and poor performance exactly selling points. The HFRI Fund Weighted Composite Index, a commonly used benchmark, fell 4.8% in 2011, its second annual decline in four years.
Steep minimum investments and capacity limits have also deterred investors, as has the global financial crisis. At the end of 2010, the wealthy had just 5% of their financial assets in alternative investments, including hedge funds, down from 10% in 2006, according to the 2011 World Wealth Report from Capgemini and Merrill Lynch Wealth Management. Hedge fund holdings accounted for 24% of their alternative investment assets in 2010.
But it may be time to take a closer look at the maturing industry. Hedge funds embrace a wide variety of strategies and niches, some more conservative than you might expect. They're also coming under greater scrutiny because of the Dodd-Frank act and other legislation. Additionally, the industry is putting more emphasis on operational best practices, compliance and investor communications as its institutional assets grow.
These were the big takeaways from a hedge fund conference recently co-sponsored in Florham Park, N.J., by Eagle Rock Partners and professional services firm Rothstein Kass. Managers of 11 hedge funds (two held by the Eagle Rock Diversified Fund LP) spoke to an audience of mostly accredited high-net-worth investors, as did wealth advisors invested in this space.
So how are hedge fund managers approaching different niches, and what's their big appeal?
Some funds focus on reduced volatility and increased return. These are the main benefits of the Gargoyle Hedged Value Fund, for instance, which buys undervalued U.S.-listed companies and sells relatively overpriced call options on the S&P 500, the Nasdaq and the Russell 2000 indexes. The strategy works well because index options are overpriced more than 80% of the time. "This is one of the worst kept secrets on Wall Street," says Josh Parker, managing partner of investment strategies at The Gargoyle Group, a 24-year-old Englewood, N.J., firm that specializes in options.
The drawback with these options is that if the market goes up a lot, you've capped your upside potential. But the options smooth out the rate of return over the long term and reduce volatility by 20%, Parker says. The strategy also provides Gargoyle with some tax efficiencies, although he notes that index options aren't always tax-advantaged.
Why value stocks? "It's a slow, steady, conservative approach," says Parker, whose fund holds a basket of about 100 stocks. "We're not top-down guys, we're bottom-up."
High-yield debt in emerging markets and distressed debt are the focus of Greylock Capital Management LLC, an SEC-registered investment advisor with operations in New York, Singapore and Ghana. "If you see a crisis and everyone swings to the exit, we go in," says Hans Humes, president and chief investment officer.