If all this sounds far afield from traditional investing, it is. One of the first things to understand about advising in this arena is the commitment to education it requires, and not just for you and your staff. "Client education takes a good deal of time," says Brad Stark, co-founder of Mission Wealth Management LLC in Santa Barbara, Calif. The fiduciary's job is to make sure the client is comfortable with the risk undertaken. "You have to explain the strategy as well as the investment vehicle so that the client knows what to expect," Stark says.

Besides appreciating what his risks are, "the client should understand what his risks are not," adds Kitces, alluding to the misconceptions many clients have about hedge funds. The wide variety of strategies practiced by these vehicles means the advisor must convey that not all hedge funds are the same.

Certainly you need to emphasize that with upside potential comes the possibility of losing wealth, says Domenic DiPiero, principal at Newport Capital Group in Red Bank, N.J. Suppose the client enthuses that Paulson Credit Opportunities Fund returned 589.9% last year after being launched as a hunch that the mortgage market would crack. You should quickly counter that two leveraged Bear Stearns funds went belly-up investing in subprime mortgages.

Of course, you can't educate the client about the risks until your due diligence on the investment is complete. "You really have to do your homework to get a handle on the true risk of the underlying investment," says Stark. Managers may helm some 10,096 hedge funds, but talent is not equal across the board.

Secrets Of A Hedge Fund
Revealed (To Some)
The problem for advisors is that transparent information on hedge funds can be tough to come by. These managers tend to jealously guard their unique trading models and proprietary information. "It's very much a buyer-beware market," says DiPiero. His client base includes hedge fund industry-types, giving his firm rare access to this exclusive world.
"When a knowledgeable client who we know is unbiased explains to us that a certain manager really knows his stuff, we spread the word to our other clients. A lot of it goes on reputation, like a lay person choosing a physician," DiPiero says.
Lee is also "in." Having analyzed hedge funds since 1989, he knows folks in the biz. What if you don't? "They'll talk to you-if you're going to put $250 million with them. Size is a real factor in this," Lee says, noting that as more institutional money pours into the funds, it becomes harder for even very wealthy individual investors to garner pull.
Even with access, due diligence is costly. Lee Financial has two analysts devoted to hedge funds, plus support personnel. "You have to develop a whole skill set. If you don't do it right, you're just asking for trouble," Lee says.
There are third-party vendors who supply data on private funds for you to evaluate on your own. Or try your broker-dealer, if you have an affiliation. Fidelity, for instance, gives advisors access to a tool enabling them to get information on SEC-registered hedge funds participating in Fidelity's Alternative Investments Network and to compare them side by side or against industry benchmarks.
Another choice is a fund of funds. With these, a manager assumes responsibility for the due diligence on the underlying hedge funds. Of course, the investor pays for that with an extra layer of management fees.
Hedge funds' lack of transparency was one factor that led Kitces' firm to mutual funds. Some are subadvised by real hedge fund managers (who hold this money separately, of course). But they all are regulated, so disclosure of holdings is required. The knock is, you don't get the performance.
Lipper's equity market neutral mutual-fund category underperformed the HFRI Equity Market Neutral Index, which measures the returns of approximately 150 hedge funds, by 194 basis points in 2007 and by an average of 2.43% annually for the last three years.
Morningstar data has similarly shown that mutual shares tend to underperform their hedge fund counterparts, according to John Rekenthaler, the Chicago company's vice president of research and new products. Why? Because a hedge-fund-like mutual fund is still not a hedge fund, Rekenthaler says. Regulations limit its ability to act like a true hedge fund, he says, adding that open-end funds can only pursue "the tamer hedging strategies."

The Search For Liquidity
Still, mutual funds offer daily liquidity. That makes it easy to rebalance or change the client's strategic asset allocation, Kitces says.
Not so with hedge funds, which are somewhat illiquid. They often launch with a one-year lockup period (read: no redemptions) and provide only quarterly or semi-annual exit windows after that. Some may sport shorter lockups and more frequent liquidation opportunities, but even so, if the fund's strategy starts to backfire, you may not be able to get the client out in time. "And after liquidating a position," Stark says, "it can take 30 to 60 days to receive the majority of the proceeds, and longer to get the full amount."
Illiquidity breeds valuation issues. "Most private funds report their value once per month, generally two or three weeks after month end. It lags," says Stark.
Regardless of when this important data becomes available, capturing and incorporating it into performance reports can be troublesome. The data may have to be entered manually into your portfolio reporting system. (Ugh. However, some custodians offer open-architecture platforms that can help avoid this. Schwab and Fidelity, for example, receive valuations from the funds they support, print the values on client statements and send the data to your portfolio management software so you can track performance.
But then what do you benchmark to? A spread of 300 to 500 basis points above cash is what Morningstar's Rekenthaler hears the hedge fund industry throw around. Planner Thomas Meyer offers an intriguing approach. "We try to have a hedge in every asset class. We might use Janus Adviser Long/Short in the value space, as one example," says the president of Meyer Capital Group in Marlton, N.J., who dedicates as much as 15% to 20% of an asset class's allocation to hedges against it. That way, each asset class's return, which can easily be benchmarked, incorporates the results of its hedged strategies.
Tax Considerations
Many hedging strategies generate significant short-term capital gains due to frequent trading. For the right client, tax efficiency could be gained by investing in hedge funds through a private placement life insurance contract. (See "Insurance Companies Work Hedge Funds Into Their Act," Financial Advisor, June 2005.) Or you could hedge in the client's individual retirement account, although some hedge funds are only structured for taxable accounts, Stark notes.
With taxable accounts, remember that public mutual funds report on the tidy Form 1099, while many hedge funds instead send their investors complicated Schedule K-1s, and usually not on a timely basis. Investors in private funds should expect to file their taxes under an extension and pay more in accounting fees-perhaps significantly more, Lee says. "That absolutely has to be considered in cost-justifying the investment."FA

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