Similarly, Wescap Management Group in Glendale, Calif., started its own hedge fund of funds 11 years ago. "When the fund was started, there was simply no other practical way to participate in the many hedged strategies," says Mark Gleason, senior financial advisor at the firm.
While the Wescap fund lost 3% in 2002, it has achieved average annual gains of 11% since creation and a cumulative return of 15% over the past three years, he says. The due diligence involved in such an undertaking includes visiting with hedge fund managers, checking on custodial records and background checks on fund principals, he says. "It is time intensive," Gleason says. "You've got to see if they're doing what they say they are doing."
The need for such scrutiny and the lack of transparency when it comes to how hedge funds operate are, however, among the reasons many advisors have decided seek investment alternatives in other ways. Tom Davison, senior financial advisor with Summit Financial Strategies in Columbus, Ohio, opts to use a mix of the arbitrage-strategy Merger Fund, REITs and international bond funds unhedged to the U.S. dollar as market diversifiers. He has had his eye on several fund of hedge fund products, including those offered by Undiscovered Managers, J.P. Morgan and Ascendant, but is holding off until they build up a track record-while noticing a drop-off in the number of new fund of funds products.
"Last year we'd get a call a week from someone that was launching a new product," he says. "Those calls have dried up recently."
Among the reasons he steers clients away from hedge funds is the lack of hard information that is available for due diligence. He cited one client who independently invested in one successful hedge fund, but was unable to confirm the prices of its investments in its audited financials. The report noted that all prices could not be verified because they were independently provided by the fund manager-a common practice with hedge funds. "We call the hedge fund and ask what percentage of the financials are priced this way, and get the run-around," Davison says.
Another practice that dissuades him from hedge funds is managers closing down funds and starting new ones when they feel performance is too far out of reach of high-watermark performance fees.
These concerns, he says, are not completely resolved with the fund of funds approach because even these vehicles provide only limited transparency. "What the fund of funds people's message comes down to is, 'Trust me,'" Davison says.
Hedge funds can work as a market diversifier-if you find the right ones, says Gary Greenbaum, partner in Greenbaum and Orecchio, wealth managers in Old Tappan, N.J. That job has been made easier by the fact that the hedge fund market is no longer dominated by macro strategies that "can turn on a dime" without investors knowing about it. Five years ago, such funds made up 70% to 80% of the market, compared with about 10% to 15% today.
Greenbaum says his firm concentrates on index and arbitrage hedge funds-ones that are more dependent on style than an individual manager for positive results. "We're not part of the alpha-chasing crowd," he says.
At FirstTrust in Daytona Beach, Fla., investment managers integrate hedging techniques into its investment strategy rather than relying on hedge funds, says Chris Cannon, director of the firm's investment division. "The net effect is we haven't had nearly the downside in the overall portfolios that we would have had we maintained our kind of old, limited choices," he says.