Wealth Manager

Courting the man in the street with hedge funds and the
like is a growth industry—literally, in some cases. Imagine
that you’re strolling down South LaSalle Street in Chicago,
or Fifth Avenue in New York. Suddenly, you develop an
urge to buy into a limited partnership focused on trading
futures. You’re in luck: Superfund Asset Management just
happens to have walk-in shops on both streets, offering
managed futures investments for as little as $5,000.

Yet no one should assume that America is on the leading
edge of bringing alternative investment strategies to the
masses. For those who crave hedge funds in their unadulterated
form—sans minimums and offering daily liquidity
and a relatively high degree of transparency—it’s time to
look abroad.

The listed hedge fund is unknown in the United States, but
the concept has a following on exchanges in Britain, Switzerland,
Canada, Australia and elsewhere. The first listings date
to 1996 on the London Stock Exchange (LSE) and the Swiss
Stock Exchange (SSE), reports ABN Amro Bank’s London office
in Alternatively, its listed-hedge fund research publication.

This is a good time to emphasize that offshore-listed
hedge funds are a breed that is distinct from the handful
of hedge fund management companies that trade
in the U.S. Shares of Fortress Financial and Blackstone
Group, for example, change hands on the New York Stock
Exchange, but those are the stocks of companies that run
hedge funds. The shares represent ownership in the operating
businesses—not the underlying funds. Similarly, no
one should confuse shares of T. Rowe Price Group, whose
shares are listed on Nasdaq, with the firm’s mutual funds.

The London-listed hedge funds confer ownership in the
hedge fund portfolios proper. For example, purchasing
Dexion Absolute Ltd., a fund of hedge funds that trades
on the London Stock Exchange under the ticker DAB, is a
hedge fund investment, pure and simple. Okay, but what’s
the practical value for U.S. wealth managers and their
clients? London-listed hedge funds are off limits to U.S. investors,
right? Not necessarily, and so the choices for hedge
fund investments are broader than is generally known for
U.S. investors.

Depending on the brokerage firm, buying shares on
exchanges around the world can be fairly routine and inexpensive.
Interactive Brokers, for example, offers a trading platform
to U.S. investors—both individuals and professionals—that accesses
70 international stock, bond and derivatives exchanges.

Buying hedge funds on foreign exchanges may be easy, then,
but is it prudent? Let’s start with positives. For those who
have been bitten by the hedge fund bug, the offshore choices
are worth a look. One reason is that there’s an extra layer of
regulatory scrutiny associated with exchange trading generally.
Listing shares on the London Stock Exchange and other
bourses comes with basic requirements on matters of corporate
governance, accounting, reporting investment results, etc.
that apply to all listings there. In that sense, listed hedge funds
are regulated securities. No wonder that listed hedge funds
usually have Web sites offering a range of information on the
portfolios including holdings, investment strategy, performance
history and related data.

By comparison, U.S.-based hedge funds (excluding the
mutual fund variety) are considered “lightly regulated.” In
exchange for the minimal oversight, hedge funds in the U.S.
agree to limit investors to institutions and wealthy individuals.
Yes, many U.S.-based hedge funds are registered securities
via the SEC, but they still don’t trade on exchanges, nor
are they required to publicly report performance and other
related data.

Listed hedge funds in Europe, on other hand, are available
to anyone with a brokerage account, and they offer a
high degree of reporting transparency. As for the choices,
ABN Amro in London tracks 42 listed hedge funds, representing
more than £10 billion under management, as of
May 2008. Most are funds of hedge funds, which invest in
a variety of other single-manager hedge funds. The listed
funds of hedge funds are of two types: internal and external.
The internal variety owns a mix of the parent company’s
single-manager funds; the external FOFs look to managers
outside the firm.

Whatever U.S. investors think of the idea, listed hedge funds
are a growth industry. The rising level of assets under management
is one clue. Another indication of the trend is the rising
presence of listed hedge funds in stock market benchmarks.
As of this past May, eight of the London-listed funds of hedge
funds had sufficient size and trading liquidity to earn
a spot in the FTSE U.K. All-Share index.

The basic design of listed hedge-funds is
akin to a U.S. closed-end fund. As a result,
market prices can and do fluctuate around net asset value,
which creates an extra layer of opportunity, as well as risk in the
form of discounts and premiums.

There are a number of investor-friendly features with listed
hedge funds, but what’s in it for the issuers? First is the ability
to transfer the redemption burden to the secondary market
for trading shares. That’s a potentially large benefit for funds
holding illiquid investments, since it allows management to
minimize, if not eliminate, the potentially destabilizing task of
meeting large redemption requests at awkward moments.

Marketing is another plus. Some institutional investors,
including some pension funds, are prohibited from buying
unlisted securities. By listing hedge funds on exchanges, managers
can broaden their investor base.

Yet hedge fund managers that go the exchange route don’t
go all the way. According to ABN AMRO, all managers with
listed funds raise the bulk of assets by means other than
floating shares.

Despite the plusses, U.S.-based investors should not dive
into the pool of listed hedge funds blindly—if at all. Taxes and
foreign currencies are complicating factors. Another potential
problem: Some listed hedge funds shun U.S. investors.

“There are a number of companies that formally state that
there must not be any U.S. investors on the shareholder register,”
says Mark James, who follows listed hedge funds for ABN
AMRO in London.

That’s not an obvious obstacle, since U.S. investors can
generally find a way to buy whatever they want on foreign
stock exchanges. In fact, the Greenwich, Conn.-based Interactive
Brokers recently confirmed for Wealth Manager that
trading London-listed hedge funds was just a keystroke away
for U.S. clients.

Taxes and forex, however, are not so easily resolved. “My
current understanding is that U.S. investors should not
invest in listed funds in taxable accounts,” advises Mebane
Faber, portfolio manager at Cambria Investment Management
in Los Angeles. The trouble stems from what’s known
as passive foreign investment companies (PFICs). Given the
rather harsh treatment for U.S. investors regarding PFICs, it’s
best to own listed hedge funds in tax-deferred accounts, such
as an IRA, he says.

None of this discourages Faber, who reports that he’s
looking at LSE-listed hedge funds as possible investments
for Cambria’s high-net-worth clients. He cites the usual
hedge fund charms, such as bringing diversification to a
portfolio of conventional assets. Meanwhile, with listed
funds “You get around a lot of the problems you otherwise
have with [non-listed] hedge funds,” he explains. “There are
no liquidity issues, there are no lockups, and there’s a lot
more transparency.”

That leaves the foreign exchange issue. Purchases of London-
listed hedge funds necessarily clear in sterling. Unless
you’re interested in making a bet on the pound, buying an
LSE-listed fund requires an offsetting forex hedge. Fortunately,
forex hedging is easy and inexpensive with options,
foreign currency ETFs and other products.

But let’s not kid ourselves: Even the most rabid U.S.-
based hedge fund advocates will probably never look at a
foreign-listed hedge fund—much less buy one. Given the
complications and risks of offshore investing even in the
21st century, perhaps it’s all for the best.

That leads to the question of why there are no exchangelisted
hedge funds in America. In search of answers, Wealth
Manager spoke with a number of sources, ranging from a
spokesman at the SEC to analysts and lawyers specializing
in hedge funds. A typical response: The hedge fund industry
isn’t interested in publicly floating shares of its investment
funds for U.S. investors.

“We as an association, and our members, don’t have any
interest in turning hedge funds into a retail product,” says Ben
Allensworth, senior legal counsel at the Managed Futures Association,
a Washington, D.C. trade group representing hedge
funds. “We think hedge funds work well when they’re sold to
sophisticated investors through private placements. That’s the
way the industry has developed over here, and we think that’s
the appropriate marketplace for it.”

Presumably, the preference is partly to protect John
and Jane Doe from undue risks in the marketplace. Well
intentioned, perhaps, but not entirely logical. Sure, there
are some aggressive hedge funds that court high risk; some
even blow up. But there is no shortage of ways for retail investors
to lose money in, say, levered and short ETFs, penny
stocks, forex trading accounts, and even blue chip stocks
that suddenly look a bit less blue.

If hedge funds are too risky for the average investor, then
so too are a fair number of mutual funds and ETFs. Indeed,
you don’t have to look far to find some mutual funds registered
under the Investment Company Act of 1940 that assume
comparable, and even higher levels of risk than some
of the hedge funds of funds listed in London.

No doubt some intrepid firm will one day breach industry
protocol and list a hedge fund on an American exchange.
Meanwhile, the lines between hedge funds and so-called conventional
investment strategies have blurred to the point that
real-world distinctions are often non-existent.

As for listing hedge funds in the U.S., the main criticism
from the industry seems less about protecting Joe Sixpack
than keeping the SEC at arm’s length in regulatory matters.
Restricting hedge funds to the privately offered niche helps
keep regulators at bay, but how this helps the average investor
is certainly not obvious.