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Funds Enter Risky Hedge Fund Market

With mutual fund sales down, equity fund performance in the red and fund groups seeing star managers jump ship to navigate their own hedge funds, fund advisors are considering ways to offer alternative investment products.

Franklin Templeton is in the hedge fund mode. This past January star fund manager Mark Holowesko stepped down from day-to-day portfolio management to spearhead a new hedge fund offered through the group's Templeton division.

Furthermore, Franklin recently disclosed that Lawrence Sondike, a Senior VP and member of the management team of the Franklin Mutual Series funds will be stepping down from his role on Sept. 30 in favor of developing new alternative investments for that Franklin unit. A hedge fund is in the works, confirmed a Franklin Templeton spokeswoman.

Last month the parent company of OppenheimerFunds of New York purchased Tremont Advisers, a hedge fund firm. AIM Management of Houston is poised to soon launch its first hedge fund. A spokesman declined to be more specific. And Dreyfus Corp. of New York confirmed that it, too, is looking into offering alternative investments.

As a whole, alternative investments sport some attractive benefits. That's according to a new study released a few weeks ago by Undiscovered Managers, a mutual fund advisory company in Dallas. Undiscovered Managers is itself considering whether to offer alternative investments, said Mark Hurley, the firm's CEO at a recent meeting in New York.

The Alternative

Investment Appeal

The report, "Alternate Investments & the Semi-Affluent Investor," notes that until now, many advisors had not considered launching alternative investments, such as hedge funds, private equity funds, Real Estate Investment Trusts, or third-party fund-of-funds, because equity markets had been providing strong returns.

But with industry soothsayers predicting shrinking or even negative returns over the next several years, advisors are seeking ways to attract affluent investors, and keep valued fund managers from seeking greener pastures.

In addition, advisors are anxious to siphon off some of the assets expected to flow into alternative investments. "Hedge funds now represent one of the fastest growing segments of the investment management community," noted the report. Despite its growth, the hedge fund industry is still in its infancy, with assets under management expected to reach $1.7 trillion by 2008, a 250% increase from today's $480 billion invested (see chart).

According to the report, alternative investments offer clients additional portfolio diversification, and can offer significant positive rates of return, especially when other investment vehicles are posting negative performance numbers. Moreover, advisory firms can use their alternative product offerings as a method by which to differentiate their firm from others.

Alternative Investments Pose Threats

But the report issues a clear caution to firms contemplating moving into the alternative investment arena. By their very nature they also carry their own risks, provide less transparency to clients, are more expensive to operate and can require additional regulatory burdens that advisors must carefully review.

Firms seeking to offer hedge funds face another hurdle. They must overcome the checkered reputation of the hedge fund industry fueled by several past high-profile scandals involving abuses by hedge fund managers, as well as some recent negative media attention.

Moreover, noted the report, advisors will have to decide for themselves whether to develop their own alternative investment products or sub-contract these investments to third parties, which often requires extra due diligence and may increase a firm's liability, making it difficult to obtain the standard Errors and Omissions and Directors and Officers liability insurance.

Besides developing hedge fund products, fund advisors may look to offering fund-of- funds vehicles. While there are three forms a fund-of-funds may take, advisors are increasingly looking to build these pooled alternative investment vehicles, which are registered with the SEC under the 1940 Act, said the report. These fund-of-funds aren't limited to only 100 investors, have lower minimum investment thresholds and have a board of directors providing oversight. "We'll see lots of these," said Hurley. "They will look like a mutual fund and will be '40 Act registered."

But fund advisors must tread carefully and not try to do too many things at once, Hurley said. He pointed to the Scudder Weisel alternative investment fund that was disbanded earlier this year. The hedge-like fund, which was created last Fall through a partnership between Zurich Scudder Investments of New York and investment bank Thomas Weisel Partners, simply combined too many sophisticated investment strategies into one fund, Hurley said.