Introducing clients to hedge funds

Many financial advisers are familiar with the asset allocation strategies and diversification benefits achieved by Harvard University of Cambridge, Mass., and Yale University of New Haven, Conn., through investing in hedge funds.

Many financial advisers are familiar with the asset allocation strategies and diversification benefits achieved by Harvard University of Cambridge, Mass., and Yale University of New Haven, Conn., through investing in hedge funds.

Typically, however, adviser practices fall into one of three categories when it comes to hedge funds and client portfolios:

1. Those who avoid hedge funds entirely for a variety of reasons.

2. Those who recommend hedge funds occasionally in response to a competitive situation or client request.

3. Those who embrace hedge funds for all appropriate clients.

COMMON MISTAKES

Regardless of which category characterizes your practice, the following are common mistakes we have witnessed when dealing with the topic of hedge funds:

• Ignoring the subject altogether. As a professional adviser, you can’t ignore hedge funds’ effect on the capital markets. Would you rather have your valued clients learn about their complexities from you, the popular media or one of your competitors?

• Defining hedge funds too narrowly. Too often, advisers wrongly characterize them as relying on a single strategy, such as long-short equity or global macro trading.

• Defining hedge funds too broadly. Many advisers define all hedge funds as aggressive vehicles looking for big returns with a lot of risk.

NEXT CHALLENGE

These descriptions do not reflect the vast diversity of strategies and risk-return objectives that exist within the hedge fund arena.

For those advisers who have embraced the concept of hedge funds, or funds of funds, and enjoy access to attractive products through their broker-dealer firms, the next challenge is how to introduce these strategies to clients. This goal is reached by setting proper return expectations, fully disclosing risks and characterizing the overall role of hedge funds within portfolios.

There are several common mistakes that occur in this phase.

Advisers sometimes set improper return expectations. Too often, the term “absolute returns” is used to set performance expectations, implying that hedge funds should make money all the time. As soon as an absolute-return fund has a negative period, clients may question if they should hold on to the investment.

To be sure, many clients have been conditioned by the financial industry to compare all returns with the Standard & Poor’s 500 stock index. Clients may question why they hold a hedge fund if it has lagged the market during a given period.

In addition, many clients have exaggerated return expectations for all hedge funds and consequently might be unimpressed with the performance of a diversified portfolio of hedge funds they own.

Other advisers downplay risk factors. Focusing on the investment strategy and historical performance of a recommended hedge fund is the single largest mistake an adviser can make in this area. Emphasizing the risk factors found in the offering documents can actually help clients understand the positives of hedge funds more effectively.

For instance, explaining that hedge funds are illiquid means that managers can employ more-complex strategies without having to plan for daily redemptions. Further, higher fees can account for why some of the most talented investment professionals in the world manage these products.

Finally, some advisers commit to a meaningless allocation. It amazes us how many allocations are made at a fund’s investment minimum, regardless of the investor’s portfolio size. If you are going to take the time to research the investment, discuss it fully with the client and fill out the paperwork. Commit to a 5% to 10% allocation of the portfolio.

These mistakes can be avoided by leveraging your ex-tended team of experts.

Most capable firms targeting the high-net-worth market have an established alternative-investment area with specialists standing ready to assist your practice in evaluating products and communicating their potential benefits and risks.

Investing in hedge funds requires specific levels of risk tolerance, sophistication and resources to perform adequate manager selection as well as due diligence.

Those resources exist at many firms and await your call.

Patrick O’Connor is a vice president for wealth solutions at Raymond James Financial Inc. in St. Petersburg, Fla.

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