Tuesday, July 26, 2011

Hedge Fund Investing:: High Reward - and Higher Risk

Before we get to the important topic at hand, let me introduce myself. My name is Keith Ogden, and I’m a co-founder of Sanctuary Wealth Services and a “reformed” veteran of the hedge fund industry.

So you wanna buy a hedge fund, eh?

Hedge Funds are hot!. After a couple of years of outflows, hedge funds are back in vogue. But before the taxable investor jumps into a fund or a fund of funds, there are a few things to consider. Among the most important: While hedge funds can deliver outsized rewards, they can be significantly more risky than many other types of investments.

Understand your market risks. While all investors realize that they have to take some risk to earn positive real returns, it is important to consider the source of the returns. When you look at investing in a single hedge fund manager or a fund of funds, are the returns consistent with the returns available in the areas in which they invest? Madoff supposedly achieved double-digit returns in an investment strategy in which mid-single digits were the norm. While there are some superstar managers, massive outperformance over short periods of time usually signals either significant style drift or highly leveraged bets. Your hedge funds should have investment processes that are understandable to you and repeatable by them. You want to make sure you are getting adequately rewarded for the actual market risks your manager is taking.

Beware the asset gatherers. Many hedge funds with long track records tout market-beating returns from inception. But don’t forget the power of compounding. That manager who has an 18% annualized return over the last five years might be riding the benefits of a huge first year or two, when assets were probably much smaller. (Do the math: 55% in year one, followed by four 5% years is more than 18% annualized.) There is a significant body of research that suggests the returns earned by funds between $500 million and $1 billion are significantly better than those earned by funds over $1 billion. Some managers will continue to raise as much money as possible, even though the additional assets might make it all but impossible to earn significant risk-adjusted returns in their market segment.

Understand The Fees. A typical hedge fund works on the “2 plus 20” fee formula. They get 2% of the net asset value of the fund in addition to 20% of the profits. The manager typically makes more on management fees than on performance fees if the underlying returns are less than 12%. In fact, a 2% fee is more than the fee assessed by the average stock mutual fund. Then there is the 20% profit share. Investors really need to think whether their hedge fund manager has the ability to outperform the historical performance of the S&P 500.

Don’t get us wrong. Hedge funds can be a terrific investment for the right investor. But they need to be carefully considered. In my next blog I will discuss liquidity and transparency, after tax returns and the “alignment of incentives.”

Stay tuned.

Read Part 2

Friday, July 1, 2011


The burning question for many advisors each day is: “How do I monetize my business?”

The conventional answer is: “I’ll sell my business some day at a lofty premium to an unwitting bank, wirehouse or roll-up firm and ride it out until retirement.”

Many independent advisors will be relying on the greater fool theory to strike a rich deal. Independents know that larger institutions and roll-ups routinely overpay for an advisor’s book of business. The word on the street is that buyers frequently overestimate how much advisors can cross-sell and grow their business.

For their part, buyers believe their brand is the magic elixir. A new advisor’s book of business, they believe, hasn’t been more profitable because the advisor didn’t have Brand X’s killer portfolio of products and services and management expertise.

The High Road

Is a sale based on the greater fool theory really the best approach for advisors and clients? The short answer is no.

Clients don’t commit to an advisor thinking the advisor will sell the business. Clients engage advisors because they trust their advisor and they believe the advisor is competent. And, just like no one gets married thinking they’re going to get divorced, clients believe they’ll be with an advisor and the advisor's firm for the long term when they hire the advisor.

Independent advisors often think that because their unconflicted model has more integrity than a big bank’s or brokerage’s that they may be more enlightened in considering how a sale impact clients. In fact, money corrupts. An advisor has to make an active choice to take the high road.

Looking For A Fool

The greater fool theory has currency because as long as institutions have been buying books of business, they’ve been overpaying. A premium is typically paid when an acquirer overestimates the value of any one of these three variables:

1. The retention of the advisor's current clientele.

2. The ability of the advisors to continue to grow their business.

3. The strength of the acquiring firm’s brand to generate more fees from the advisor's current clients.

To earn the full purchase price, advisors must commit to generating more revenue. For clients, that’s almost always trouble. The bargain that advisors make with their new employers translates into more client solicitations and sales pressure to buy additional products and services. This is the approach especially championed by banks. Or, it could mean raising client fees. Sometimes, it is both.

On balance, the transaction is negative for clients, even if clients gain access to additional investment solutions. For advisors, there may be an upfront, short-term gain, but they forfeit the longer-term payday that comes from building and maintaining an independent firm.

A Better Way

What’s a better approach?

For both advisors and clients, the solution is remaining an independent firm and continuing to grow the business, even after the founder has retired. By having an orderly succession plan and grooming a successor, there is no need to sell.

There are two key benefits in this approach.

First, clients will fare better. Clients will transition to a new advisor who is apprenticed by their current over a two- to three-year period. The new advisor will continue to use the same products and services that the client enjoys.

Second, the retiring advisor can actually make more over time. The profitability and ownership formulas common today will pay the retiring partner on a sliding scale over a number of years even after they retire.

To achieve this objective, there must be a defined succession plan that gives the junior partner an opportunity to buy an ownership interest using contractual metrics over a defined time period. All parties must have a willingness to take the long view of the franchise for the benefit of all.

An independent wealth management firm that sells to a big bank or roll-up firm is no different than a broker who takes a big recruiting check from a wirehouse. The good news is that by remaining independent, an advisor can do right by clients and by themselves creating a win-win scenario consistent with their independent mantra of always acting in the best interests of the client.