The events of the past several weeks — indeed, of the past 15 months — have only exacerbated retail investors’ growing dissatisfaction with the performance of traditional, actively managed mutual funds. In the first quarter of this year alone, investors seeking better returns withdrew a net $30.3 billion from stock funds, according to AMG Data Services.
Two alternatives, passive index funds and exchange-traded funds, have been taking up some of the slack. In the first quarter of this year, such funds saw positive net flows of about $10 billion. I believe the time has come to allow retail investors to take advantage of a third alternative: hedge funds and funds of hedge funds.
Hedge funds have already become an increasingly popular investment vehicle for institutional investors. Between 2003 and 2007, pension funds and other institutions almost doubled their direct investments in U.S. hedge funds, from $138 billion to $255 billion — thanks primarily to the strong returns generated by these types of funds. The HFRI composite index — a proxy for the hedge fund industry — boasted an annual average return of 13.3 percent from 1990 to 2007, trumping the Standard & Poor’s 500 index, which returned just 10.3 percent a year during the same period.
Along with higher returns, of course, comes greater risk, which is why the U.S. government has long prohibited retail investors from investing in hedge funds. Yet these investors have developed a greater appetite for alternative investments, a higher tolerance for risk and a desire to participate in the wealth creation of hedge funds. With the increased availability of financial information, individual investors have also become better educated about the risks implicit in hedge funds. They understand the importance of diversifying their portfolios into areas where the returns are uncorrelated with the overall market — especially when the market is as challenging as it has been recently.
Retail investors in the U.S. deserve the freedom of choice increasingly available to investors overseas. In Australia, for example, hedge funds have been available for several years to retail investors through registered investment management schemes. The U.K. recently approved the promotion of funds of hedge funds to the general public — bringing the country in line with Germany, Ireland, Italy, Luxembourg and Spain.
Meanwhile, asset managers in the U.S. are launching mutual funds that replicate hedge fund strategies in hopes of satisfying retail investors’ appetite for uncorrelated returns. Goldman, Sachs & Co., for instance, in June announced the launch of a mutual fund designed to track passively the results of absolute-return hedge fund strategies. The new GS-Art Fund is allowed to invest in a wide range of products, including futures, swaps, exchange-traded funds, commodity structured notes and equities, as well as cash. And Natixis Global Associates recently launched two beta-replication funds that track and mimic the returns of a group of hedge funds.
What should retail hedge fund products look like? Overseas pioneers on the retail side of the industry suggest some possibilities. While essentially similar to current hedge fund products, retail hedge funds will likely use less leverage while offering lower risk profiles. The registered investment management vehicles available to retail investors in Australia offer minimum investment requirements as low as A$2,000 ($1,292) and flexible investment conditions like easier redemptions and shorter initial lockup periods than traditional hedge funds.
There are, of course, risks for hedge fund firms as they move to enter the retail market. They will need to find experienced retail partners to aid in the distribution of alternative products to individual investors, or go it alone. Firms may also have to tame the nimble, risk-taking culture of hedge funds to accommodate a more cautious retail approach. That could involve changes in operating models, with firms deciding to separate the retail business from their traditional, higher-risk operations — and compensating each side according to their differing expected returns, which would likely mean lower fees at least for the retail business. With retail products will also come increased regulation and disclosure, and the need for firms to register as traditional investment managers. That in turn will require enhanced internal controls, as well as extensive new processes for managing risk.
Every hedge fund firm must decide for itself whether these risks are worth the potential rewards that may be gained by tapping into the retail market.
Michael Spellacy is a partner and managing director in the New York office of Boston Consulting Group and leads its alternative-investment practice.
