Hedge funds for the masses

Will 2007 see the beginning of a large-scale retail distribution of hedge funds, similar to the well-established mutual fund industry?

The development of hedge funds has been the salient feature of the asset management dynamics of the last twenty years. Hedge funds assets are estimated by the Chicago-based Hedge Fund Research Inc. at $1.225 trillion at the end of the second quarter of 2006. They are expected to continue to grow at double-digit rate for at least five years.

Yet, despite substantial increase in the size of assets under management and of the number of managers, economics of hedge funds remained substantially the same, with high level of fees and substantial profit participation. As a result, the ownership of hedge funds has remained largely confined to high-net worth individuals and sophisticated institutional investors.

The persistence of high-cost economics is explained by two features: hedge funds are extremely heterogeneous and therefore not easily amenable to standardisation. The other pertinent feature is they are lightly regulated, which in most countries prevents their marketing to non-professional investors. The one significant exception is Australia where hedge funds are freely available to all investors. A recent article by the Economist pointed out two interesting facts of the Australian markets. The first one is the high popularity of hedge funds. The value of hedge funds held by individual was estimated at 24 billion euros and represented two-third of the total hedge fund investment. The second is that their performance is in line with traditional investments. According to the Reserve Bank of Australia, their return, after expenses, was comparable to that of the broad stock index.

This would suggest that if there was a way of reducing management costs, hedge funds performance would be substantially improved. To give just an example of the impact of the costs, let’s take a look a hedge-fund-like fund listed on NYSE, Alpha-Hedged Strategy FUND (ALPHX), which has the highest Morningstar rating (five stars). Its expense ratio is 3.01%. This may looks like much, but it means that over three year period, investor pays to fund managers 17% of their initial capital ($1,709 out of $10,000). Not surprisingly, while ALPHX shows respectable three year return, it substantially underperforms the S&P index.

How one would go about developing true retail hedge funds, or, in other terms, low-cost hedge-fund products? In our view, this would imply focusing on two structural characteristics of hedge fund: the ability to sell short and the opportunity to provide multi-asset class exposure (stocks, bonds, commodities). However, the low-cost imperative would entail that short selling would be limited to indices and asset classes rather than to specific instruments. On the other hand, the number of asset classes should be restricted to three or four. Also, in order to keep the cost down, the low-cost hedge would have to have a considerably lower holdings turnover (which for hedge funds is, on the average, superior to 200%). In a nutshell, a retail hedge fund would be built around three key features:

- Short-selling indices and asset classes proxies

- Exposure to three to four asset classes

- Low holdings turnover.

One approach could be to construct five to ten specialised funds and to let users play managers of funds of funds, in a way that Fidelity or Charles Schwab does, by restricting the number of times asset allocation between various funds could be carried without commission.

One important question is whether the distribution of retail hedge funds should be structured around online providers of financial services. So far, the experience of online distribution mutual funds is inconclusive: they did not become a best-selling product or critical competitive advantage for any online brokers, either in Europe or in the US, but over time they provided an useful complement of product offering. This can be explained by two reasons: first, for users, financial portals are seen primarily as a set of unbundling tools, affording them an opportunity to construct their own portfolios. Second, the distribution channels for mutual funds are already well-established and quite efficient. Furthermore, traditional distributors such as Fidelity or Schwab answered rapidly the online challenge and are now among largest online players.

Hedge fund industry structure is very different and, at least in my view, offers considerable scope for a new entrant, who would focus on low-cost online distribution.

Call me ignorant or irresponsible but I believe that the time for hedge funds for the masses has come.