By Jonathan Chevreau National Post FP Investing Section Tuesday, August 10, 2004

As the hedge fund industry approaches US$1-trillion in assets, it's attracting more than its share of pot shots.

Fresh on the heels of the damaging "Sleaziest Show on Earth" article in Forbes magazine, bond guru Bill Gross has added to the skepticism with his "Lemonade for Sale" essay on his Web site www.pimco.com.

Gross -- managing director of California-based Pacific Investment Management Co. (PIMCO) -- predicts hedge funds will be weighed down by their own success. "Greed leads to intense competition and excessive fees. Both of these should eventually reduce the product's average investment return to something approaching mediocrity."

But the stinging part of Gross's attack is his suggestion that not only are the barriers to entry non-existent, but that intelligent investors could essentially "build their own" hedge funds at far less cost.

Here's how he puts it: "If you're thinking about a hedge fund to bolster your portfolio returns, give it a long think. They're risky and they're generally overpriced. You can do better elsewhere or even on your own."

Bryan Nykoliation, marketing manager at Toronto-based hedge firm Blumont Capital, bristles at this sweeping and "erroneous" generalization. Gross, he says, "appears to put very little value on professional money and risk management."

Gross also fails to mention the enhanced diversification a "fund of funds" provides, Nykoliation argues. "A principle objective of any hedge fund investor should be to select something better than the average hedge fund."

If picking hedge funds sounds suspiciously like the game of chasing hot mutual funds, that should come as no surprise.

They're similar businesses: both charge hefty fees on the premise "active" security selection can outperform cash or the indexes. It's no surprise many mutual fund managers "graduate" to running their own hedge funds.

Both industries have no trouble wriggling out from the accusation that in the long run, all outperforming funds eventually regress to the mean. There's always some outperformer they can point to. It's just unlikely investors can identify them long enough in advance to benefit.

The major difference is hedge funds are less regulated and let managers indulge in arbitrage, shorting, leverage and other tricks. They also add a twist mutual funds might well consider emulating: paying a bonus to managers if they outperform. This is the famed "2 and 20" model: a 2% flat fee and a 20% bonus on profits beyond a certain threshold.

Hedge funds are where mutual funds were in the early 1980s, which means the hype has just begun. To the extent its history recapitulates mutual funds, we can expect a surge in hedge fund advertising and more media coverage.

If the same patterns hold, we can expect years of glowing profiles of hot hedge fund managers, regular newspaper supplements on performance and magazine cover stories on "The top 7 hedge funds you simply must buy now."

Criticism of fees and performance may at first be muted, but the press may become more critical earlier because it's seen this movie before.

The Financial Times is devoting regular space to hedge funds, and in even-handed fashion. One recent headline posed an apt question: "Should investors fear a crisis, or simply disappointment?"

This column has cited indexing advocate Larry Swedroe, who views hedge funds as merely another product to be sold rather than bought -- like mutual funds.

Indeed, the two industries have similar sales structures, which is cause for concern. If history repeats, we can expect some egregious sales practices, the entry to the business of hordes of commission-hungry rookie salespeople, and a new slew of seminar shills.

Inevitably, not all these new hedge players will be reputable. The danger will be self-serving recommendations and the kind of "suck the equity from your home" leverage suggestions which plagued the mutual fund industry as the 1990s bull market screeched to a halt.

I don't personally own hedge funds nor do several knowledgeable sources I respect. However, I am also acquainted with advisors who see nothing wrong with using hedge funds to diversify and hedge downside risk for a portion of a portfolio.

Adrian Mastracci, a fee-based advisor with KCM Wealth Management in Vancouver, recommends hedge funds form no more than 3% to 5% of a total portfolio -- considerably less than the 15 to 20% hedge fund executives suggest.

"Hedge fund products are all over the place on risks, investment returns, investment strategies and policies that they follow," says Mastracci. "Practically every client tells me hedge funds are not suitable for them when they answer the question in the 'Know Your Client' form."

Fund analyst Dan Hallett is in the process of researching the Canadian market and so far found only one hedge product (Abria Diversified Arbitrage Trust, a fund of funds) with which he's comfortable. "I have yet to actually recommend a hedge fund for any of the portfolios on which I've directly advised."

Despite allegedly risky practices like leveraging and shorting, as a group hedge funds have "managed to generally contain risk," Hallett says.

Another risk is lack of transparency, since hedge funds are reluctant to let investors peer inside what amounts to an opaque "black box," an ongoing problem with alternative assets in general. "A great deal of due diligence is required," Hallett says.

That's the central point of John Mauldin's book, Bull's Eye Investing, which makes the positive case for hedge funds.

But exercising such due diligence is a challenge given the amount of information available on them, Mastracci concludes.

NOTE: The information provided above is intended for general informational purposes only. It does not constitute advice for anyone's specific situation. Everyone should always first consult directly with their advisors to determine the appropriateness of any information contained above before taking any action. KCM Wealth Management Inc. assumes no responsibility for any loss or damage arising from the use of, or reliance upon the above information.