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Trickle-Down Economics: Hedge Funds Aim Lower

Call it trickle-down economics. As the hedge fund industry continues to grow, its distribution channels are shifting, and its aim is getting lower when it comes to the net worth of investors, according to a report from Tiburon Strategic Advisors.

Tiburon estimates that the $1.9 trillion industry will grow to $3 trillion by the end of the decade. While some of that growth will come from the increased interest of endowments, pensions and other institutional investors, much of it will come from high-net-worth-as opposed to ultra-high-net-worth-investors, with as little as between $600,000 and $1 million to invest.

"The channels are changing," said Charles "Chip" Roame, managing partner of the market research firm outside of San Francisco. Hedge fund managers are reaching a new, broader market, through funds-of-funds, hedge fund indexes, variable annuity wrappers, and even mutual fund structures subject to the regulations of the Investment Company Act of 1940 and ERISA-controlled 401(k) and defined benefit plans.

Many of these products will run in tandem with the conventional hedge funds already under managers' control. And while these products will not be able to command the 20% performance fees that, in some circles, have made hedge funds notorious, they will levy expenses of between 6% and 8%, as opposed to somewhere between 1.5% and 2% charged by the average actively managed mutual fund.

"You're seeing the industry grow up right now, and I think that's good for everyone," Roame said.

But not everyone agrees that the so-called institutionalization of hedge funds is good for the industry. Robert Driscolo, who is in charge of hedge fund strategy at AIG Global Investment Group, suggested that many hedge fund managers are "notching it down" and taking fewer risks to attract more institutional investors. "I am not happy about it," Driscolo told BusinessWeek. Driscolo did not return calls to Money Management Executive seeking comment.

Others, though, say it's not a matter of being skittish, it's a matter of being smart about investors' money in the current market climate. After all, big windfall gains are one side of what a hedge fund does. The other side is protecting assets their investors already have, said Lee Schultheis, chief executive and chief investment strategist at Alternative Investment Partners of White Plains, N.Y. "The protection to the downside is what ultra-high-net-worth individuals and institutions are most interested in: to stay risk-free and make money second," he said.

Roame added that many shoot-the-lights-out hedge funds changed their strategies in the early part of the decade when the market tumbled and they got socked. That led to a greater emphasis on fixed income arbitrage, convertible bond arbitrage, distressed security arbitrage and other techniques that exploit market price inefficiencies.

But that's not to say these instruments are without risk. Thirty-five percent of all hedge funds still fail, according to Tiburon, mainly due to operational inefficiencies, such as being flooded with cash that managers can't move fast enough to place.

Still, the appeal of not losing in slipping markets does have a mass appeal, said Margaret Gilbert, a managing director at Greenwich Alternative Investments, a hedge fund research and investment firm in Greenwich, Conn.

"If you take a look at the last bear market, hedge fund investments were in positive territories," she said. "I think there is an appreciation for not following an equity index. The investor doesn't want you to track it all the way down 40% when the index drops 40%," she said.

Such protection is something that appeals to everyone, including high-net-worth professionals planning for retirement, said Roame. That creates an opportunity for companies that can repackage hedge products in mutual fund structures to put on 401(k) platforms.

Schultheis' funds, which, for the most part, are distributed though financial advisers, already appear in a few such plans, he said. Those who buy into the funds, which have a $10,000 minimum initial investment, believe that for 600 or so basis points, what they get is a transparent structure of carefully vetted, high-performing managers to whom they may not otherwise have access, he said. Furthermore, the funds must be valued daily and offer greater liquidity, Schultheis added.

Companies like Rydex, Schwab, UBS, Potomac and AXA Rosenberg are already rolling out hedge fund-like products. Roame says the trend will continue.

With new products comes the repeated threat of more attempts by the Securities and Exchange Commission at regulation. The simplest solution might be to regulate the plan administrators, rather than the funds, requiring them to invest only with hedge fund managers who are registered, said Thomas R. Westle, a managing partner at Blank Rome in New York.

That wouldn't hamper managers' strategies, Westle said. "It just means they've got another authority to answer to."

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