Taking the Mystery Out of Hedge Funds


investing to more investors through funds of hedge funds. Such funds combine investments of as little as $100,000 from many investors and invest large portions of the total in selected hedge funds. “You’re getting access to several different strategies,” says Lyons. “The argument is that your diversification is going to be better.” Among the merits of funds of hedge funds is that by investing in hedge funds that use a range of strategies, they ensure against taking a big hit if a single fund tanks.

“If you invest in one hedge fund,” says Brian Mathis, managing partner of Provident Group & Asset Management in New York City, “maybe they have a home-run year or maybe they have a disaster. I’m spreading your dollars across 15 hedge funds, so even if one has a disaster you can still win.”

Funds of hedge funds carry one big drawback: On top of the cost of the hedge funds they invest in, the products often charge their own annual management fees of 1% as well as incentive fees of up to 10%. But proponents say the research that investors gain by turning to fund of hedge fund managers is worth it.

Fund of hedge fund managers have the clout to make hedge fund managers take their calls and inform them about how their funds work, says Lyons. They know how to combine different strategies and managers, and they can often use their scale to negotiate more favorable fees.

The potential benefits
While billion-dollar losses understandably garner widespread media attention, most hedge funds are not that volatile. Well-run funds can be used to cushion an investment portfolio against fluctuations
in the stock and bond markets. “We are advocates of using hedge funds as part of a diversification strategy,” says Matthew England, a private client adviser with Wells Fargo Private Bank in Santa Barbara, California. That’s because, along with other “alternative investments” such as real estate and venture capital, hedge funds are said not to be correlated to the direction of stocks and bonds; if the stock market goes down, a hedge fund’s returns aren’t necessarily pulled down with it.

Hedge fund managers pride themselves on finding ways to beat bear markets, bull markets, and anything in between, says Bill Thomason, head of 8-year-old Thomason Capital Management L.L.C. in Oakland, California. “In theory, with a hedge fund, you should be able to make money on either side of the market, under any conditions, if you are a good enough manager.”

The potential pitfalls
Pulling rabbits out of hats doesn’t come cheap. Hedge funds can charge a 2% management fee, double that of the typical large-cap stock mutual fund. What’s more, their managers generally take a whopping 20% of any profits the fund makes. According to Alpha magazine, which follows hedge funds, the average compensation of the top 26 hedge fund managers in 2005 was $363 million.

To justify that kind of pay, some managers ratchet up the amount of borrowed money they use, hoping to amplify small returns into larger ones, warns financial planner Brooks.


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