Avoiding the fees and egos of hedge funds

The Baltimore Sun

Imagine hedge funds without brainy managers maneuvering artfully through short-lived market opportunities day in and day out.

You might think the flashy hedge-fund arena could never evolve into this. But with about $1.2 trillion in assets, the industry is maturing. And as it does, analysts are looking for ways to capture the advantages of hedge funds without the tremendous fees and egos that go with the territory.

Attention is turning to what is known as passive investing. That's the term that applies to index mutual funds, and that means setting up a portfolio and keeping it intact without human tinkering day to day.

What's envisioned for hedge funds tends to be somewhat different than mutual funds. The focus isn't on replicating an index like the Standard & Poor's 500, but can be on identifying the special elements that power various types of hedge funds and then building those mechanically into a portfolio.

Academic studies suggest this can be done, and potentially at a low cost, said Ryan Tagal, director of hedge-fund research for Morningstar Inc.

Wall Street is increasingly intrigued with the possibilities.

"As the hedge-fund industry matures, and it becomes increasingly difficult for many investors to identify and invest in the top-performing hedge funds, passive management should gain wider appeal with hedge-fund investors," Merrill Lynch derivatives analyst Benjamin Bowler said in a recent report.

He notes that with the sharp growth of hedge funds, it is becoming tougher for active managers to excel. In that environment, he said, it's also more difficult for "investors to justify paying hedge fund fees for the performance of the average active manager."

So passive alternatives represent a natural evolution in an increasingly mature industry.

The typical hedge fund charges 2 percent of assets and 20 percent of profits, fees that pension funds and wealthy individuals are willing to pay for the best and the brightest who truly enhance returns with unique strategies. But with so many new hedge funds competing, it's becoming increasingly difficult to employ strategies that others aren't exploiting.

Bowler notes that when the mutual fund business became crowded, and many failed to outperform the S&P; 500, the environment gave birth to index funds. Because index funds don't pay for expensive talent and other costs involved in active management, they tend to perform better than active managers.

The Vanguard Total Stock Market Index fund, for example, charges 0.19 percent, while the average mutual fund charges 1.4 percent. With the low costs, the fund has beat 75 percent of active large-cap funds over the last 10 years and averaged an 8.56 percent annual return.

Since 1990, passively managed mutual funds have grown from 2 percent of stock mutual fund assets to about 17 percent.

Many pension funds use index funds for about 40 percent of their stock market exposure. Then they try to enhance returns with talented active managers. Increasingly, that's meant using hedge funds.

Bowler said the passive approaches could include tracking hedge fund benchmarks by mechanically investing in all hedge funds using an investable benchmark, perhaps a device similar to an exchange-traded fund or a mutual fund that mimics the full array of hedge funds. Passive investing also could involve investments in liquid assets that statistically track hedge fund returns, or the funds could mechanically invest in the basic strategies similar to those hedge funds execute.

Contact Gail MarksJarvis at gmarksjarvis@tribune.com or leave a message at 312-222-4264.

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