A Back Door Entry into Hedge Funds

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Hedge funds are famously exclusive, but here's a way you can indirectly hire a good manager .
 
Hedge funds often score huge gains by taking big risks and investing in ways mutual funds are not allowed to. And unlike mutual funds, which advertise, hedge funds usually add new clients only through word-of-mouth referrals. Most require initial investments of at least $1 million.
 
With this entry fee, you may assume that these funds are out of reach. But don't be surprised if you are already using a hedge fund manager. Starting in 2006, mutual fund managers were required to disclose all the funds they oversee. For the first time, it became evident that hundreds of mutual fund managers also run hedge funds. In the financial industry, such professionals are known as “side-by-side” managers. 

Should you seek a mutual fund manager who also oversees hedge funds? Yes, says Tom Nohel, associate professor of finance at Loyola University in Chicago, who studied 155 side-by-side managers. Nohel found that mutual funds of side-by-side managers outdid peer groups by 1.5 percentage points a year. “The people who manage both kinds of funds really do better,” Nohel says. “The results could suggest that the best mutual fund managers may be recruited to run hedge funds.”
 

Vanguard is a leader

Side-by-side managers may be particularly important for fund companies that rely on subadvisors, freelancers who manage money for many funds and clients. Vanguard Group, a large user of subadvisors, has proven adept at hiring the best side-by-side managers. Vanguard's side-by-side stars include Edward Owen, who has overseen Vanguard Health Care, which ranks as the best-performing member of its category for the past decade, and Sam Wilderman, who runs part of the assets of top-ranked Vanguard Explorer.

To be sure, side-by-side managers can be tempted to favor their hedge funds because of fee structures. While a hedge fund manager can earn more than 20% of a portfolio's profits, a mutual fund manager gets relatively slim rewards—generally 2% of assets or less and no share of the returns.

Because of the fee structures, a manager has an incentive to boost hedge fund performance—even at the expense of his mutual fund. To avoid cheating fund shareholders, a manager must be scrupulous. If he gets shares of a hot stock, the manager must distribute the investment equally to hedge funds and mutual funds. A manager shouldn't use the mutual fund to buy shares from the hedge fund at excessive prices.
 
Aware of the potential conflicts, regulators and academics have been combing through the data, looking for signs of cheating. Lately the side-by-side managers appear clean, says professor Tom Nohel. Vanguard Group says that it monitors side-by-side managers closely, making sure that mutual fund shareholders get fair treatment. Fund executives argue that if they didn't allow top managers to run all the various vehicles, star employees would jump ship and spend all their time with hedge funds—a loss for mutual fund investors.
 
To find out if your fund manager also oversees a hedge fund, consult the mutual fund's Statement of Additional Information. This material is available on the SEC's website (www.sec.gov). In some cases, you can bypass the SEC site and instantly get data through a Google search. By searching for “Diamond Hill Statement of Additional Information,” you can quickly learn, for example, that Chuck Bath, portfolio manager of top-performing Diamond Hill Large Cap, also runs a hedge fund.
 

Deciphering code words

In some cases, the disclosures don't use the word “hedge fund,” but they give away the secret by noting that the managers run “unregistered funds” or charge “performance-based” fees. These are code words for hedge funds, which are not necessarily registered with the SEC and usually reward managers with a percentage of the profits. Translating such legalese, it is possible to determine that John and Nick Calamos, the star managers of Calamos Growth mutual fund, also run hedge funds.
 
Along with announcing who runs hedge funds, the new disclosures provide information about the total assets each manager oversees. For example, John Calamos manages about $35.6 billion in mutual funds, $11.7 billion in private accounts, and $348 million in hedge funds. This is important information be-cause managers sometimes become overwhelmed with assets, and their performance suffers.

By considering the new data, you can get a better idea of whether your manager may be taking on too much. “When you are trying to decide whether a manager can run more assets, you have to look at everything, including responsibility for hedge funds and mutual funds,” says David Kovacs, senior portfolio manager of Turner Investment Partners, a fund company.

How big is too big? Morningstar provides some rough guidance on when investors should start worrying that their managers are overwhelmed. The fund tracker looked at the median sizes of funds that had closed to new investors because the portfolios were too big. This suggests what levels the managers themselves thought were appropriate. The median size of the closed large-cap funds was $18 billion, while funds investing in medium-size companies closed at $3 billion, and small-company funds at just $800 million. When total assets reach the marks suggested by Morningstar, anyone—even a top side-by-side manager—may have trouble maintaining good results.

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