When the dollar amounts AT stake are in the billions, even trillions, it should come as no surprise that hedge funds continue to generate a lot of buzz.
Indeed, assets in the exclusive investment pools total more than $1 trillion, and a recent study by Deutsche Bank estimates another $110 billion will flow into hedge funds this year. And of course where there’s demand, there’s supply. As wealthy individuals, endowments, pension funds, and others have poured money into hedge funds, their number has swelled to 10,500 worldwide.
Yet experts say hedge funds remain poorly understood: Most investors know them as the funds that make headlines by either delivering eye-popping returns or dramatically imploding. Investors are puzzled, however, by what exactly hedge funds are, how to get access to them, and how to choose between them. Even the term “hedge fund” is murky because it encompasses an enormous range of investment types.
While many hedge funds still require a minimum initial investment of $1 million, it has become increasingly possible for investors with more modest assets to jump on the bandwagon. “Hedge funds have become more accessible,” says Gareth Lyons, a hedge fund analyst for Morningstar Inc. “You need certain assets and income to qualify, but a lot of them are lowering their investment minimums.” In some cases, investors are accessing hedge fund strategies for as little as $2,500 through mutual funds that employ a similar approach.
What is a hedge fund?
“Using the term ‘hedge fund’ is sort of like saying, ‘I’m a doctor,'” says Rick Brooks, a financial planner in Solana Beach, California. Just as physicians run the gamut from brain surgeons to podiatrists, hedge funds vary widely in terms of investment strategy and risk level.
However, hedge funds do share some broad similarities. For starters, like a mutual fund, a hedge fund pools its investors’ money and puts it to work in the market. But an important difference is that hedge funds are private and generally fall beyond the reach of government regulation. (Though they do not have to register with the Securities and Exchange Commission, hedge fund managers have certain fiduciary responsibilities to their investors.) What’s more, because hedge funds are not allowed to advertise, their operations are commonly perceived as secretive. There’s not a lot of widely available information on particular hedge funds, in part because managers don’t want to inadvertently do something that might trigger an SEC inquiry.
They’re dubbed “hedge” funds because managers can invest in several financial instruments to help reduce–or hedge–risk or to bolster returns. One of the key differences between a hedge fund and a mutual fund is that many hedge fund managers are able to take short positions in a stock, which allows them to benefit if a stock’s price drops. When a manager “shorts” a stock, he or she is borrowing shares from a broker and selling them at the current market price. The hope is that the share price will fall, allowing the hedge fund manager to repurchase the shares at a lower price and repay the broker.
Some hedge funds also borrow money to pump up their bets. This serves to magnify results and can produce spectacular gains–as well as stomach-churning losses.
Such was the case with Long-Term Capital Management. Founded in 1994, the hedge fund racked up annualized returns of more than 40% over four years. But in 1998, it lost a staggering $4.6 billion in less than four months and finally closed two years later.
There’s one type of hedge fund that aims to generate returns that may be modest but consistent whether markets are rising or falling. Such “market-neutral” funds may buy stocks or derivatives whose prices seem likely to rise–while also borrowing and selling shares of other companies whose prices seem likely to fall.
Because of hedge funds’ limited regulation, it’s hard to find comprehensive data that assuredly represents the performance of a typical fund. Certainly there have been studies, but many findings come with caveats. For instance, How Smart are the Smart Guys?–a study by John Griffin, a finance professor at the University of Texas, and Jin Xu of Zebra Capital Management–examined the equity holdings of 306 hedge funds from 1980 to 2004 and found that there’s “weak statistical evidence that hedge funds are better at stock picking (1.32% per year) than mutual funds.” But they found that that outperformance was due largely to the tech stocks held in 1999 and 2000.
Not just for billionaires
Hedge funds have existed since at least the mid-20th century, and for most of that time they have been the province of the superrich. The emergence of mutual funds that employ hedge-like strategies shows the extent to which the idea of hedging portfolio risk has become more mainstream.
Starting in the 1980s and 1990s, hedge funds began to attract money from institutional investors who sought to hedge market risk and increase returns. Steep declines in many of their portfolios as a result of the dot-com crash only sparked further interest.
Melanie Dean, owner of Dean Financial in Nashville, Tennessee, says that about three years ago hedge fund investing began to be seen as a legitimate option for more investors. “Before that, it was considered high-risk and unscrupulous, almost like buying penny stocks,” says Dean, who adds that 17 of her 50 high-net-worth clients use hedging strategies in their portfolios.
But investors have become open to alternative investments in recent years, she says, partly because they have had to as old-school pension plans are rapidly being replaced by employee-directed alternatives such as 401(k)s. Dean counsels her clients, all of whom let her manage at least $100,000 of their money, to expose no more than 10% to 15% of their portfolios to hedging strategies.
True hedge funds remain exclusive, however, because they are available by law only to “accredited” investors–those with an income of more than $200,000 a year for individuals, or $300,000 for couples, for each of the past two years or individuals with a net worth exceeding $1 million.
In time, demands from the market led companies to open up hedge fund 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. However, if the market moves in the wrong direction, losses can also be magnified.
In the case of Long-Term Capital Management, investing nearly $30 of borrowed money for every $1 of its own assets led to disaster. When the Greenwich, Connecticut-based fund’s investments didn’t pan out, lenders demanded their money back. Long-Term Capital Management was forced to quickly sell off holdings at steep losses to make the repayments.
Or, to maintain high returns year after year, some hedge fund managers make huge bets like those that last year sunk $9 billion Amaranth Advisors, which was also based in Greenwich. The fund’s managers disastrously misjudged the natural gas futures market. At least 83 U.S. hedge funds, which at their peak managed some $35 billion, closed up shop in 2006.
Hedge funds have other drawbacks, including hefty table stakes. The standard minimum investment has long been $1 million, but the SEC recently made a recommendation to increase the minimum to $2.5 million. But even for funds that require less, investors need to be prepared to face a “lock-up period” ranging from possibly six months to five years, during which time the funds cannot be withdrawn.
The risks and the fees–not to mention the significant capital gains tax hits that cut into hedge fund returns–should give pause to ordinary investors who see hedge funds as a clever way to beat the market. “Don’t get too allured just by their cachet,” says Morningstar’s Lyons. He says the best way for the average investor to use hedge funds is as a diversifier, to protect against declines in other parts of their portfolio.
Lyons recommends, as one alternative, mutual funds that use hedge fund strategies. While those funds offer some leverage and can use strategies such as investing long and short, they don’t offer as much leverage as hedge funds. They also are a lot more liquid and don’t require a lock-up period. Plus, they are more affordable (see “Hedging Without Getting Clipped,” Moneywise, March 2006).
Edward Witherspoon, a 54-year-old retired
computer field engineer in suburban Nashville, opted for that approach two years ago. As of mid-April, his stake in the Rydex Hedged Equity Fund (RYSTX) returned 7.2% over the past 12 months, versus a 14.9% return for the S&P 500. “I try to consider investments that are in line with quality, rather than get-rich type investments,” says Witherspoon.But what’s really attractive is that the fund is more affordable than a typical hedge fund. The H-class shares that Witherspoon owns require a minimum initial investment of $2,500.
How to find the right fund
Finding a suitable hedge fund, or fund of hedge funds, on one’s own is tricky, in part because of the restrictions on advertising.
A good way to a find a fund of hedge funds is through advisers, says Mathis. If an investor wants to get into a particular hedge fund, he or she should contact the fund and ask for the names of the funds of funds that invest in it. “Almost every hedge fund worth investing in has fund of hedge fund investors in it,” he says.
But the best way to find a hedge fund or fund of funds is through high-net-worth advisers who have access to hedge fund experts and research. Take note: Some advisers know their way around the hedge fund world more than others, and some won’t touch hedge funds because of liability fears.
“Because hedge funds don’t have the same transparency as mutual funds, I’m not willing to make that bet with my clients’ money and my practice,” says Stacy Francis, president of Francis Financial in New York City.
Part of the value of using advisers is that they can use their influence to pry more information from hedge fund managers than most individuals, explains England. “Because of the lack of regulatory oversight, being a self-directed investor when it comes to hedge funds can be a slippery slope.”
Die-hard do-it-yourselfers should read as much as possible about hedge funds. A good place to start is Investing in Hedge Funds by Joseph G. Nicholas (Bloomberg Press; $34.95). Also, attend hedge fund conferences if possible. There are also online resources such as www.hedgefundcenter.com, www.hedge fund.net and www.morningstar.com, which provide information about fund managers, historical performance, and fees. Note that some of the information may be accessed only by accredited investors. For complete beginners, there’s even the recently released Hedge Funds for Dummies by Ann C. Logue (Wiley Publishing Inc.; $24.99).
Access to hedge funds may become easier as the industry continues to grow. And while it may be possible to remove some of the mystery that surrounds hedge funds, their complexity and the high stakes required may ensure that their club of investors remains one of the most exclusive there is.