Soros serves as warning to mutual-fund investors

By Chuck Jaffe, MarketWatch

July 31, 2011, 12:01 a.m. EDT

BOSTON (MarketWatch) — There was a lot of speculation this week about the reasons why legendary money manager George Soros is shutting down his hedge fund and sending investors their money back.

Some said the 80-year-old Soros — who has run the Quantum hedge funds since the late 1960s — doesn’t want to face the heightened regulation of hedge funds that’s part of the Dodd-Frank legislation. Others suggest he wants to focus on his philanthropic and political causes, and still others suggest he is protecting his investment legacy, because Soros’s record is no better than average in highly turbulent market conditions.
Whatever the reason, Soros’s decision — his firm will return outside investors’ money but continue to operate like a family business — should not go unnoticed by ordinary fund investors.

If one of the most successful hedge-fund managers of all time is hanging it up in current market conditions, what does that say for the future of all of the open-end mutual funds and exchange-traded funds that have “alternative” or hedge-like characteristics?

It’s particularly worth answering that question in light of a sentiment survey of hedge-fund managers released by Infovest21, published by Investment News this week, which showed that many managers expect other hedge-fund operators to follow suit and start returning client money to run a family operation, just like Soros. (Clearly, since those other managers aren’t all octogenarians, avoiding additional regulation and transparency is a key motivating factor.)
The wrong kind of volatility

Hedge-like mutual funds have been a booming part of the fund business for more than a decade now, but that trend has corresponded with a big macro-economic cycle that favored commodities investing, a cornerstone of many hedge/alternative strategies. For anyone who believes in looking at the biggest possible picture, the stretch of time that favored those investments is getting long in the tooth. That would suggest that some alternative strategies that have been popular and successful — the kind that cemented Soros’ legacy — may be in for rough times.

Even if you don’t subscribe to that biggest-picture view, there is no denying that many hedging strategies do best when the market is volatile, but with a strong sense of direction. Many market-neutral and long-short strategies — hedge strategies designed to profit no matter which way the market moves — struggle when the market lacks a trend.

“There is a growing, yet subliminal, sense of expected overall lower volatility moving forward,” said Stephen L. McKee of Investment Selections & Timing Inc. in Dallas. “For some, it doesn’t matter the direction as long as the direction is severe; that might be disappearing... Tighter circuit breakers, a more intertwined, cooperative world financial system, greater regulation of those on the edges will all contribute.”

For the rest of us, McKee noted, lower volatility would be a positive, but for many hedged strategies it’s a problem. Just as hedge funds have high costs — typically 2% of assets plus 20% of profits — mutual funds with hedge-like strategies tend to have above-average costs. Even the exchange-traded funds following alternative strategies are pricey compared to peers pursuing more mainstream tactics.

It’s fine to pay for performance, so long as you actually get it. That hasn’t happened for most hedge/alternative funds; instead, they’ve been all sizzle and no steak.

Russel Kinnel, director of mutual-fund research at Morningstar Inc., said investors should be less concerned with Soros’s departure than with all of the famous guys who enter and exit the business without fanfare.

“The hedge funds and hedge-like mutual funds that flop are the ones that should be of concern to investors,” Kinnel said. “The fact that so many have not succeeded despite the fact that the managers sound like brilliant rocket scientists is a concern. But Soros seems to me more to represent the promise of them. He and others show that there are hedge funds that can do well.”
Don’t wait for another Soros

That doesn’t mean average investors should hold out hope for the “next Soros” to show up in the fund game at a time when the first Soros is leaving the biz.

Industry consultant Geoff Bobroff of East Greenwich, R.I., noted that many of the biggest, best-known fund firms have no offerings in the hedge-like or alternative space. “Maybe you could say they missed the boat or are behind the curve,” he said, “but you can’t say their investors are missing out, because you can reach your goals with mainstream funds that have solid track records and understandable strategies.”

And that’s why Soros’s departure reminds ordinary investors not to fall in love with the idea of investing like the wealthy in a hedge-fund style. Hedge-fund tactics don’t always work in mutual funds, and if the market is entering a time when those strategies don’t even work for hedge funds, average folks should steer clear.

“Investors should stick with what they know and can understand; not based on someone they think they know or whom their friends claim to know, not based on claims of a better mousetrap without a few furry grey skins thumb-tacked above the trap to prove it, not based on what they think will make them the most money quickly,” said Jim Lowell, chief investment officer at Adviser Investments in Boston. “The biggest risk to investors is assuming the like of Soros know more about the markets than they do; leaving them prone to all kinds of spellbinding claims.”

Chuck Jaffe is a senior MarketWatch columnist. His work appears in many U.S. newspapers.