The mysterious and lucrative world of hedge fund investing could be coming to a brokerage near you … and sooner than you think.
Recent changes to federal and SEC oversight removed the marketing ban for hedge funds that has been in place for decades. Hedge funds are supposed to be targeted toward accredited (read: high net worth) investors as well as institutional and pension funds. But because of changes in the rules, the retail investing set can now access these funds.
And private-equity kingpin Blackstone (BX) is here to help.
The investment manager has filed paperwork to launch the first retail mutual fund that will seek capital appreciation by allocating assets among a variety of investment sub-advisers. These managers will focus their attention on a variety of nontraditional or “alternative” investment strategies.
So basically, the new Blackstone Alternative Multi-Manager Fund (BXMMX) will be a “fund of funds” hedge fund.
The real question is whether the Blackstone fund — and the others that are currently in registration — are worthwhile products for regular Joes. The answer comes down to whether you understand what you’re buying.
Don’t Expect Home Runs
The main problem with hedge funds is public perception — and not just the hatred for the excessively luxurious lifestyle some of their managers lead.
The issue is that most investors associate hedge funds with wild returns. During the 1990s, as the dot-com boom was growing, many prominent hedge funds saw insane returns and gave birth to the idea that the fund structure was about “knocking it out of the park” year after year.
However, the truth is hedge funds use a variety of non-traditional strategies to try to offset risk, or “hedge.”
Short selling, derivatives, options, futures and other exotic strategies are used to provide consistent returns, even in downtrodden markets. Traditional mutual funds generally rely on the stock market to go up as managers buy a stock because they believe its price will increase. At least in principle, for hedge funds it makes no difference whether the market goes up or down. They aim instead for absolute returns.
Absolute returns don’t always mean gains of 40%-plus a year. The reality is most absolute return funds produce a constant 5% to 7% a year. That could beat or underperform the broad stock market in any given year, but keep in mind that beating the market isn’t the real objective — it’s to make constant risk-adjusted returns.
And steady 5% to 7% returns can do wonders for a portfolio.
Alternative asset class investments offer true diversification away from equities. Over time, alternative asset classes and strategies like merger/arbitrage, long/short and managed futures deliver a significant degree of non-correlation to the both domestic and international equities markets.
From 1993 to 2012, the Barclay CTA Index — which tracks an index of managed futures tactics — had a correlation of -0.9% to the broad S&P 500. During that time, even investment-grade bonds showed a positive (albeit slight) correlation to stocks. Overall, that means bonds didn’t adequately provide a zig when the market was zagging, while managed funds would have truly moved in a direction opposite the market.
When used to complement a portfolio of stocks and bonds, “alts” could be just the right solution for improving a portfolio’s risk-adjusted returns. That non-correlation and independent return stream can potentially act as buffer for weathering the next market storm.
Which brings us to Blackstone’s new fund.
How to Use BXMMX
Blackstone’s foray into a retail mutual fund that tracks hedge fund strategies could be an interesting addition to a portfolio … but only if you don’t expect doublers out of this thing every year. It’s a diversification tool, and you should use it as such. This isn’t going to completely replace your holdings in a broad index vehicle like the Vanguard Total World Stock Index ETF (VT), and you shouldn’t bet the farm on it.
Financial advisers estimate that portfolios should have between 5% and 30% of their assets in alternatives. Personally, I’m more inclined to be on the lower end of that scale, as stocks still continue to prove themselves as the best long term generator of wealth. However, having a slight hedge still can do wonders for returns and smooth out that ride.
Keep in mind that hedges can be expensive. While these alternative funds aren’t as expense as investing in a real hedge fund, alternative mutual funds like BXMMX, the Guggenheim Multi-Hedge Strategies (RYMSX) and ASTON/Lake Partners LASSO Alternatives (ALSNX) still aren’t cheap. After adding up everything, average expenses for the category are a whopping 3.4% — or $340 per $10,000 invested — per year. Pairing one of these alt funds with low-cost index ETFs for your core portfolio should relieve some of the sting of high total portfolio expenses.
So is BXMMX is a good fit for average Joes? Yes and no. Buying on the assumption that it’s going to rock your portfolio’s socks off will most likely leave you feeling completely ripped off. However, if you understand the fund’s true role in a portfolio — as a diversifier — then alternative and hedge fund mutual funds begin to make sense.
Yes, they are expensive, but as a small portion of one’s holdings, they can do wonders to smooth out the market’s bumps.
Blackstone’s new fund shouldn’t be any different.
As of this writing, Aaron Levitt was long RYMSX.