Hedge Funds Losing Their Appeal?

The star power of hedge funds seems to have waned in 2006, at least among the wealthiest set. The percentage of ultra-wealthy households (those with a net worth of over $25 million, excluding primary residence) owning hedge funds plunged by almost a third last year, to 27 percent, down from 38 percent the previous year, according to a recent study by Spectrem Group, a Chicago-based consulting firm. In its study, Spectrem surveyed 526 households with a net worth of at least $5 million.

The star power of hedge funds seems to have waned in 2006, at least among the wealthiest set. The percentage of ultra-wealthy households (those with a net worth of over $25 million, excluding primary residence) owning hedge funds plunged by almost a third last year, to 27 percent, down from 38 percent the previous year, according to a recent study by Spectrem Group, a Chicago-based consulting firm. In its study, Spectrem surveyed 526 households with a net worth of at least $5 million.

Analysts and wealth managers say recent unspectacular hedge fund performance and negative headlines about hedge fund manager pay, as well as the blow up of Amaranth Advisors, which collapsed spectacularly last year due to bad bets on energy, are partly to blame.

“The population that invests in hedge funds is very knowledgeable and has been reading some of the negative stories about the industry, including the amount of money hedge fund managers make,” says George Walper, president of Spectrem Group. Hedge funds typically charge an asset-management fee of 1 percent to 2 percent of assets, plus a performance fee of around 20 percent of a hedge fund’s profits, according to the Securities and Exchange Commission.

That’s a lot to pay when you can get equal or better returns on traditional investments, says Michael Boone, certified financial planner and founder of MW Boone & Associates in Seattle. “With the S&P 500 returning over 15 percent in 2006, indexing costing only a few basis points and international and emerging markets really rocking, you can see why investors might choose to leave a lot of the expensive hedge funds behind.”

Sandi Bragar, a certified financial planner and principal with San Francisco-based Kochis Fitz, says her firm yanked all of its hedge fund investments last year—representing some $120 million in client assets. These assets were redeployed to commodities, real estate, equities and, in some cases, fixed income.

Bragar says her firm, a registered investment advisory firm with $1.8 billion in assets under management, decided at the end of 2005 that the hedge fund industry was growing too fast for its own good. “There were so many new managers and a lot of the opportunities that existed before were being arbitraged away,” she says. With more and more managers chasing the same investing strategies, it has become harder to generate big returns from those strategies. Some managers try to compensate by pushing into new territory, but that also increases the level of risk they take.

Gary Rathbun, a wealth manager with Private Wealth Consultants in Toledo, Ohio, agrees. “Not only am I seeing [HNW investors pull out], I’m recommending it. Whenever you get too many people saying ‘I can do that too,’ you’re going to see less-than-favorable results,” he says. In 2006, he pulled about $25 million in client assets from hedge funds. He’s redeployed some of that cash into private equity, currency hedges and “normal” investment strategies.

Will investors—and their advisors—continue to cool to hedge funds? It’s hard to say at this point. The plain old wealthy—those with $10 million to $25 million in net worth, excluding primary residence—don’t seem to be pulling out. Some 18 percent of these households were invested in hedge funds in 2006, down just a pinch from 19 percent in 2005. And the $5 million-to-$10 million household group actually increased its exposure—up to 8 percent from 6 percent. So, it's really the ultra-rich that are losing their appetite for the investments. “It will be interesting to see if the industry can restore its popularity among this important segment as 2007 progresses,” writes Catherine McBreen, managing director of Spectrem Group, in the research report.

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