Hedge-fund shopping in a crowded field

Hedge funds are the quintessential special opportunity: they come with the potential for high returns but are open only to high-net-worth investors.

To get in on the game, you have to be “accredited.” You fit the definition, according to the Securities and Exchange Commission, if you made $200,000 or more for each of the last two years—$300,000 combined for a married couple—and expect to reach that level again this year. Alternatively, you can have a net worth of $1 million, not counting the value of your primary home.

If you meet these standards, hedge funds may be worth considering. Their returns over the last 24 years have been 2 percent above those of the S&P 500, says Ken Heinz, president of Hedge Fund Research in Chicago. When equity markets do well, hedge funds also do well as a group, but when the stock market falls, hedge funds tend to perform better, he says: “For high-net-worth individuals, [a hedge fund] makes sense because it serves as a complement to the significant amount of equities and fixed-income and private investments they have already.”

Choosing the right hedge fund from a crowded field of some 10,000 managing $3 trillion can be challenging. Brand-name managers aren’t always the best, says Kurt Silberstein, managing director of alternative investments at Ascent Private Capital Management, the ultra-high-net-worth arm of U.S. Bank Wealth Management. He steers his clients toward “boutique” funds with between $400 million and $2 billion under management and a niche focus—for instance, healthcare or shareholder activism. Such funds are the right size to act rapidly in the market, taking advantage of deals like a $500 million high-yield bond issuance that’s too small for a larger fund to buy, Silberstein says.

“The difference between a good event-driven manager and a bad event-driven manager is huge,” he adds. “There’s a lot of mediocrity out there.”

Just 2 percent of hedge-fund managers have “a truly unique skill set and competitive advantage,” Silberstein notes. He cites the importance of having access to information others don’t have (while staying away from illegal inside information), the ability to use that knowledge to make wise trades, and the skill to structure trades advantageously.

As with any investment, performing due diligence is crucial, says Christine Johnson, managing director and head of alternatives product management at Alliance Bernstein in New York, which has $12.5 billion on its hedge-fund platform. First, filter down your list by manager’s pedigree, track record, and experience. Then ask questions about the fund’s strategy and under what market conditions the strategy will do well. Understand how the fund did in periods of market turmoil, like the 2008 global financial crisis and the 2011 European debt crisis, she says.

The questions are more pointed now that ways exist to replicate some of hedge funds’ allure. With the increasing number of specialty exchange-traded funds, it’s easier for retail investors to structure a portfolio in a low-cost fashion, focusing on particular regions, asset classes or strategies, without paying high fees.

“It’s harder and harder to find hedge funds that can outperform this cheap alternative beta on a regular basis,” Silberstein says.

Why not buy ETFs instead of hedge funds? ETFs typically do well in a bull market, as the U.S. has had for the past six years, buoyed by monetary and fiscal policy. But in tumultuous or downward markets, or when the Federal Reserve begins raising interest rates once again, it can be difficult to manage ETFs with precision. Just look at relative performance since August across various markets, Silberstein says: “Year to date, hedge funds are slightly positive, depending on what kind of strategy you’re looking at, where the markets are negative single digits or even double digits.”

Another way to buy diversification is through a so-called “fund-of-funds,” which allows you to own slices of many hedge funds at once, for an additional fee of about 1 percent. Another new twist is the publicly traded hedge fund, which operates like a mutual fund and has daily liquidity.

Hedge funds typically come with stiff fees, but those costs are dropping, Silberstein says. Once, the vast majority charged a 2 percent annual management fee on assets held in the fund, plus 20 percent of any profits. Now, only the most elite managers have that structure, he says; the standard fee today is 1.5 percent plus 15 percent of profits.

Another consideration is that funds restrict how quickly you can take your money out. Ascent recommends agreeing only to a one-year “soft lock,” in which you pay 3 to 5 percent in redemption fees if you withdraw money within the first year. Some funds don’t offer any redemption rights during the first year, but after that period, there should not be any penalty for withdrawals, he says.

Investors who decide to buy into hedge funds often start by allocating 3 to 5 percent of their portfolio in this direction, up to no more than 20 percent, spread among 12 to 15 managers, Heinz says.

Fees are an issue only when the fund does poorly; when it’s performing well, investors don’t complain about paying. “With high equity returns, it’s hard to see those fees,” Johnson says. “In a difficult environment, those fees will look very different to an investor.”

In addition to the fees, one drawback to investing in hedge funds is their high number of trades, which trigger capital-gains taxes. Another is the potential for fraud or malfeasance. Investors remember Bernard Madoff’s fund, which collapsed in scandal and criminal prosecutions during the financial crisis, wiping out his clients. But frauds like Madoff’s are the extreme exception, Silberstein says. He recommends minimizing the risk by sticking with funds that use one of the “Big Four” accounting firms and a major administrative-services firm like Bank of New York or International Fund Services, a division of State Street Corp.

Chana Schoenberger has been an editor at Forbes, an online editor for The Wall Street Journal, and a news editor for Bloomberg News.