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Needling out the best third party advice

For families wishing to invest in hedge funds there are various steps that should be undertaken to help ensure returns in this booming asset class. Reg Crowder offers some tips for first time investors who are looking to third party providers

This year is shaping up to be a year when many private investors will ramp up their investments into hedge funds. And for good reason.

Despite a few spectacular hedge fund collapses that grabbed headlines in 2007, the hedge fund industry finished the year having outperformed both the US and international equity markets by substantial margins while maintaining lower volatility. At the end of 2007, Credit Suisse Index Co released research showing that hedge funds had generated average annual returns of just above 12%. This compared to under 9% growth on the MSCI World Index and just over 6% on the Standard & Poor's 500.

Institutional investors in most of the world's major economies say they are increasing their allocations to hedge funds in 2008. Based upon the hedge fund industry's track record of above-market returns and below-market volatility, fund managers expect private investors to follow the institutions into hedge funds.

Getting started
Giles Drury, a senior manager in the Alternative Investments Group of accounting firm KPMG, was asked what the first thing someone considering an initial investment in a hedge fund should do. His answer came quickly: "The first thing a family office or the person who handles the family's investments should do is get some advice.

"There are about 10,000 hedge funds out there and most of them are pretty mediocre," he continues. "Genuine talent in investment management is a truly rare commodity."

When considering who to approach for advice on hedge fund investing, Drury believes prospective investors should give some thought to how the advisor is compensated.

"Some of those who provide capital introduction services are compensated by the funds themselves," he says. Drury wouldn't absolutely rule out an advisor who takes money from hedge funds but feels the investor should think hard about how that fact might affect the advisor's independence. "Certainly the more independent the advice, the more valuable it is going to be," he says.

Going down the fund of hedge funds route
Simon Hopkins, CEO of alternative asset firm The Fortune Group, says that when institutions make their first move into hedge funds, they almost always do it through a fund of hedge funds. He believes that families and other private investors would be wise to do the same.

"A family should have 25% to 30% of its core resources in a fund of hedge funds," Hopkins says. "The diversification that is possible gives you capital protection through all the cyclical movements that we see in business.

"The broad array of managers and strategies (in a fund of hedge funds) allows you to uncorrelate the strategies and their performance," he continues. "You can net out a positive return, even when the market is going down. Maybe it isn't a very big positive return, but you're making money, not losing it."

Keeping returns positive protects investors from the urge to sell into a falling market, he says, and advises that it is only natural for people to become upset and alarmed when they look at big paper losses in a down market. "And then they want to sell," Hopkins says. "And that is the one moment when you should never sell."

Virginia Reynolds Parker, president of Parker Global Strategies of Greenwich, Connecticut, says it was this ability to protect investors, no matter which way the market moves, that first attracted her to hedge funds.
"I was first introduced to hedge fund investing and the concept of risk management oversight in the summer of 1988," she says. "At that time, I was running very vanilla equity and fixed income portfolios for a family office. In the previous fall of 1987, we had witnessed just how quickly the US equity market could implode, spiraling down exponentially with the reverse thrust of portfolio insurance, as market participants watched in awe. What attracted me to hedge funds was the potential ability to make profits in both up and down markets."

Parker says that was still true in 2007, just as it had been in previous years. Contrary to popular opinion, the credit crunch did not bring with it a large number of hedge fund failures, she says. "It was more about the size of the funds that got hit," she explains. "Some of the funds had huge structured finance deals. Some $900 million to $1 billion funds built with structured finance went under because they were levered and long (on) bad paper. So the trouble was a few large funds."

Independent verification
New research by KPMG International and CREATE-Research reveals a powerful global demand by both institutions and private investors, and that hedge funds provide independent verification and evaluation of many of their previously invisible functions.

The study involved the participation of 239 investment managers, 61 pension funds and 48 administrators. It includes financial entities domiciled in 28 national jurisdictions. KPMG describes the report as "the most comprehensive and broadly-based research ever carried out on the future of investment management". At the top of the list of their demands were independent verification of fund performance and asset values. KPMG says the current credit crunch created a "flight to quality and simplicity."

"For alternatives (including hedge funds) to retain their dizzy growth of the recent past, they will have to … deliver a new generation of customised structured finance products with capital protection and full transparency," the accounting consultancy says.

"Investors want to see a 'Good Housekeeping Seal of Approval' via more standardised products, more stress testing, more transparent pricing of illiquid assets, more independent audits and more independent administration," says Jon Mills, a co-author of the study and a partner at KPMG in the UK.

The report said the recent turmoil in the credit markets will "force" many hedge funds to obtain third-party approval for "most of their middle office activities, including valuation and performance monitoring.

"Furthermore, there is likely to be growing demand for independent administration from high net worth individuals investing in the alternatives," the report says. "Hitherto, they have focused more on investment returns than business basics. The recent crisis is expected to force a shift in this balance."

See what the tax man is up to
David Kilshaw, a partner in the tax practice of KPMG's UK Private Client Advisory Group, believes investors need to know the tax consequences of their proposed investments before they irrevocably commit to them. But that's easier said than done. As business founders well know, business plans often reach to a horizon five years or more in the future. Unfortunately, the tax rules that govern them can change in five weeks or less.
The situation faced by high net worth individuals in the UK demonstrates the difficulty in coming out on top with the taxing authorities. "The big issue with my clients here in the UK is the government's plans for the capital gains tax," Kilshaw says. "The government said it was going to lower the capital gains tax to 18% and it was going announce its plans before Christmas. But then the Chancellor said it wouldn't be announced (until 2008)."

Kilshaw says all his clients can do is try to be ready for whatever emerges from the government. "Right now they're checking to see which of their pockets have losses and which of their pockets have gains," he explains.
Investors in all tax jurisdictions need to stay on the lookout for fast-breaking changes that could have major tax consequences, he says.

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