Thursday

High net worth?

Mainly I work with institutions and very wealthy clients. But good hedge funds are ideal for ALL investors. Why are they prevented from accessing the best? Proper hedge funds are a NEW return source and are LOWER risk than long only. Why risk capital in passive funds that do NO analysis or due diligence? Skills are reliable, asset classes are not.

1. Most hedge funds now focus on institutions. It is less total work to get one big client to give you $100 million than to get 100 clients to give you $1 million each. Some alternative investment firms have handed back or refused high net worth money in order to target institutions. Often individual investor money wasn't pulled, it was pushed. The transitive verb matters: did investors redeem or were they redeemed? Traditional long only salesmen would be aghast at the notion of turning down investors but I see it in the alternatives world every day.

2. Many advisors and consultants still don't "get" skill strategies. Many gatekeepers avoid the world's best managers. You need deep expertise to evaluate hedge funds and clearly some are reluctant when making money is so "easy". Why bother to learn how to a) differentiate alpha from beta b) construct a properly diversified portfolio or c) take steps to immunize client wealth from poor equity or credit conditions? We will never get a 2000-2002, 1994, 1987, early 1980s, entire 1970s, 1930s situation ever again, right? WRONG. We are very overdue for bear market times. Another 50% drawdown on the S&P 500 is coming.

3. Good hedge funds mostly target double-digit returns at single digit volatility. For individuals looking to PRESERVE their wealth this is ideal but for a person looking to get MUCH richer, hedge funds are NOT suitable. If a rich person so desires, there is nothing wrong with taking much MORE risk with individual stocks, mutual funds, angel ventures, art and collectibles or the high limit tables in Vegas. It is their money and they have few fiduciary responsibilities. Good hedge funds ARE indeed boring and there is little chance of a 1,000% return in the short term from a real hedge fund. Nowadays, saying you are in a hedge fund on the cocktail party circuit attracts yawns not gasps. That is a GOOD thing as it demonstrates the maturity of the industry.

4. Public relations. Hedge funds have done a poor job of explaining their value proposition in the marketplace. That is not entirely their fault as regulators prevent advertising or much performance disclosure. Also bad hedge fund stories dominate good hedge fund stories in the media. Iraq is in the news more than Bhutan so, of course, that tendency is not confined to the financial pages. But it still appears that many in the high net worth advisory community do not comprehend basic concepts like "strategy diversification", "alpha", "risk-adjusted" or "hedging". However, the hedge fund industry does carry some blame for a compelling positive message not getting through, leaving a negative perception of the industry.

5. Affluent investors are marketed to relentlessly by the street. EVERY investment bank has the same cunning plan to build up private banking and high net worth business. Stockbrokers cold call everyone on their rich lists, hoping to flog stocks and in-house mutual funds and many are paid on commission only. Proper hedge funds are focused on managing money and are often poor marketers. It is not where their talents lie and rightly so. But it does mean that the traditional "sell-side", especially during a bull market, are able to entice rich people out of hedge funds and into unhedged products, usually near the market top.

6. Some hedge funds regard institutional money as more "prestigious". I would consider cash from an individual or family office equally important since it is their OWN money that they are entrusting to advise on or manage. Institutions are simply aggregators of retail money to achieve wider diversification and economies of scale. Pension plans invest on behalf of current and future retirees. Endowments for current and future students. Foundations for whomever they are trying to help. Sovereign wealth funds for the entire population. It is ALL individual money in the end. Nevertheless there are some hedge funds out there that will ignore wealthy private individuals for a remote chance of getting some Calpers, Yale or Ford Foundation cash. And while DB plans are allowed to diversify properly, DC are not!

7. Institutional money is sticky and long term. Individuals may want their money back for a wide variety of reasons NOT related to performance. Provided a hedge fund achieves expectations, it is very unlikely an institutional investor will redeem in the short term. From a hedge fund manager's standpoint there is less business risk with larger investors and possibly less hand-holding. Some would rather pick up the phone to a $25 billion investor than a $25 million "net worth" investor. I don't think that is necessarily the right way to run a business but it is a market reality.

8. The Amaranth, MotherRock and Archeus debacles had no decision-making impact on high net worth redemptions. Rich people are well aware a tiny percentage of hedge funds will fail as much as in any other entreprenurial business venture. They also don't care much about hedge fund manager compensation provided the fund performs and the manager and employees align interests by keeping their own money in the fund. Many people became wealthy due to their own skills and are more than prepared to pay for financial talent and outstanding risk-adjusted alpha.

9. It is more interesting joining the board of that start-up you just angeled or interfacing with the architect of your new real estate project or hanging out at art auctions. A hedge fund is a stand alone investment where you wire the money over and that is basically that. While an affluent investor wanting to be proactive and involved with some portfolio investments is both logical, even desirable, there is also a strong case for hiring specialist expertise to simply get on with it. High net worth individuals choose doctors for their medical and surgical skills, lawyers and accountants for their qualifications, and hedge fund managers for their alpha and the best advisors to help pick the best FUTURE alpha generators.

10. Philanthropy is "in" and hopefully will only continue to grow. The true measure of wealth is how much you give away to good causes, NOT what you keep. The chances are a wealthy person cannot easily sell their founders' stock, real estate or private equity holdings. Meanwhile long only traditional funds are regarded as "core" investments, for some reason. Hedge funds are relatively liquid and therefore are the likeliest component of a portfolio to be redeemed to raise cash for charitable giving. There was a lot of that during 2006. Foundation investment in hedge funds is strong, so it is possible the same money stayed in hedge funds, but is now classed as institutional money, through foundations established by the high net worth individual. Perhaps some "redemptions" were simply transfers from John and Jane Doe themselves to the John and Jane Doe Foundation. The tax treatment also helps as foundations are generally tax exempt.

Interesting how some people find alternative investments "too complex", yet buy high-end electronics goods, cars and aeroplanes whose inner workings presumably they DO understand. According to the high net worth Spectrem study, the wealthy seem to comprise a smaller proportion of hedge fund assets. Push/pull factors have led to a current short term hiatus.

It has been a while since a bear market and hedge funds prove themselves in BAD economic times. The ultra high net worth, high net worth and mass affluent individuals will be back in droves once current economic conditions end. The smart, shrewd and risk averse investors already are. Wealth is not what you make, it is what you can afford to give away. Hedge funds are an essential portfolio component to ensure private wealth grows and such philanthropy is maintained.

By Veryan Allen Creative Commons License

This work is licensed under the Creative Commons Full Attribution, Non-Commercial, No Derivative Works 3.0 License

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