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Will Amaranth Debacle Curb Enthusiasm for Hedge Funds of Funds?

News of colossal losses at one of the largest hedge funds in the U.S., Amaranth Advisors, throws yet another cloud over the alternative investments.

News of colossal losses at one of the largest hedge funds in the U.S., Amaranth Advisors, throws yet another cloud over the alternative investments. At the very least, the sudden loss of $3 billion—due to wrong bets on natural gas prices—serves as a reminder of the outsized risks that clients face. And, coming after years of middling returns for the funds of funds that retail advisors sell, it raises the question of whether these pricey vehicles are worth it.

Amaranth, a so-called multistrategy hedge fund known for smart bets and strong performance, disclosed on Monday that its double-digit returns for the year had turned into a 35 percent year-to-date loss. Amaranth had $9.25 billion in assets before the spectacular downturn. Among the investors sharing those losses are funds of funds managed by Morgan Stanley, the Man Group, Credit Suisse, Deutsche Bank and Bank of New York, according to recent SEC filings.

The hedge fund industry has grown at a dizzying rate. Today, there are some 9,000 hedge funds managing $1.23 trillion in assets, up from 610 hedge funds and $38.9 billion in 1990, according to Hedge Fund Research. Fund of funds manage $426 billion. But even as the investment vehicles have become a major force in the market, they remain unregulated. In 2004, the SEC proposed a rule that would have required certain hedge funds to register with federal regulators and face stricter oversight, but that rule was struck down by a court of appeals in June, and the SEC has decided not to appeal the ruling. In the meantime, the SEC has said it plans to increase its vigilance of hedge funds through their dealings with broker/dealers.

Some hedge fund analysts were astonished by Amaranth’s losses. “Where was the risk-management team and risk-management systems?” asks one hedge fund analyst who requested anonymity. “A hedge fund with over 300 employees, of that scale, is typically expected to have extraordinarily robust risk supervision—both from a technological and personnel standpoint. What’s really shocking is that a fund that had achieved that level of prominence would stake so much of their business on one type of trade—or various trades that relied on one very volatile type of commodity. Can it really be possible that the firm didn’t know they were that exposed to natural gas?”

On the other hand, he says, the debacle could be help make a case for fund of hedge funds, which invest in a variety of different funds, thus spreading around the risk. “That’s the beauty of the funds of funds. These events happen once in a blue moon. What affect will this have on [fund of funds’] performance? Maybe they’ll be down a few percent for a month. Whereas investors who put money into Amaranth directly—they’re crushed. Rather than show that funds of funds are defective, it shows that there is a value to being diversified.”

Still, hedge fund returns have suffered in recent years, making it harder to justify the high fees on funds of hedge funds, which typically charge between 2 percent and 4 percent, or more, according to Ryan Tagal, director of hedge funds at Morningstar. “Fund of funds are supposed to produce equity-like returns with bond-like volatility,” says Tagal. “That story might have worked in the past.” But now, he says, the funds are more heavily correlated with the equity markets. “That’s the problem,” he says. “As there are more entrants into this space, the opportunities are shrinking. They’re not doing what they’re supposed to do.”

Through July, hedge funds averaged returns of 5.49 percent for the year, according to; funds of funds averaged returns of 3.87 percent. A decade ago, returns in the in the mid to high teens were common, says Tagal. Still, net asset flows haven’t slowed much: Year-to-date through the end of the second quarter, hedge funds brought in net new assets of $66 billion, and fund of funds amassed net new assets of $15.6 billion, according to Hedge Fund Research data.

Will the poor returns and spooky events like Amaranth turn Wall Street off? “It’s tough to say, especially on the advisor level, since the advisor in the high-net-worth market is still learning about hedge funds in the first place,” says Tagal.

Brian Schreiner, a retail advisor with Schreiner Capital Management, an RIA in Exton, Pa. says he has never been enthusiastic about hedge funds or funds, and he’s more leery now. “We believe in transparency and liquidity—and those are two things that hedge funds typically are not. What you see with hedge funds is there are inevitably these debacles, because basically these managers miscalculate the real risks involved in what they do.”

For his clients, Schreiner says, there are too many good traditional investments that can use a lot of the same strategies that hedge funds use. “There’s a lot of things that hedge funds can get involved in that we can never get involved in, like international real estate,” he says. “But a lot of good hedge funds will just use long-short equity, invest in metals or other commodities. Those are all things now that you can do inside of brokerage accounts.”

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