Hedge Funds

Over the past ten years, there has been tremendous growth in hedge funds. In the late 1990s, the number of hedge funds actively managing assets was less than 1,000. By early 2006, that number had ballooned to more than 8,000 funds, cumulatively managing more than $1.2 trillion in assets*. A once niche market has become virtually mainstream overnight. Despite additional coverage in the popular press, many investors remain confused about the role hedge funds play in properly constructed portfolios.

Client: What is a hedge fund?

In its broadest sense, a hedge fund is a pooled, professionally managed investment vehicle that often utilizes highly complicated strategies with the aim of generating returns in excess of the market. There are many types of hedge fund—and quite a few don't actually "hedge" anything.

Hedge funds are generally established as private investment partnerships and were originally created for ultra high net worth investors. They generally have a restrictive account minimum (often well above $1 million) and investors are often locked into the fund for a minimum period of time (anywhere from 6 months to years.)

Client: I have $500,000 in an IRA and my broker has recommended that I invest a portion of the account in a hedge fund. Is this a good idea? Is putting 10% in a hedge fund any different than having 10% of my portfolio in a mutual fund?

On a personal level, whether a hedge fund is a good idea for you largely depends on your goals for the assets, time horizon and risk tolerance.

Although hedge funds and mutual funds share some characteristics (both are pooled, professionally managed investments), there are many fundamental differences. First, hedge funds often limit the amount of access that shareholders have to their own funds. Additionally, the strategies used by hedge funds are often undefined or untested, adding additional risk. Perhaps most importantly, they are very opaque—with few standards for reporting and little regulatory oversight.

One of the key differences between hedge funds and other investments is fees. A typical fee structure is 1-2% annual management fee plus 20% of the profit. In some cases, funds will charge as much as 50% of the profit. The usual argument that hedge fund managers present is the fee rate does not matter if the net of fee returns is acceptable. However, the average performance of hedge funds is debatable, and the industry is rife with conflicts of interest since the fee structure creates an asymmetric incentive to take great risks. Even one year of huge positive returns at a 20% of profit fee can yield enormous profits for the manager, but what happens when the manager starts to lose money? Since they only gross significant revenue when the fund is succeeding, many hedge fund managers start taking aggressive risks with their clients' assets in search of positive returns. It can be painful for the investor if the risk doesn't go in their favor.

Client: Who cares about fees if the performance is strong?

The problem is many hedge funds do not deliver great long term results, and even recent hedge fund performance in aggregate has been spotty. The Credit Suisse Tremont Hedge Fund Composite, a broad measure of hedge fund performance, shows that, on the whole, hedge funds underperformed the MSCI World Index in 2003, 2004, and 2005, according to Bloomberg. This may seem surprising since every hedge fund out there seems to claim great performance. However, it is important to remember that, if a fund turns south, it is easy enough to close the fund and start a new one (thereby erasing the historically poor performance) – there is no regulatory body that says they cannot do this. In fact, a recent article in the Wall Street Journal concludes, "Something like 25% of all hedge funds every couple of years dissolve, go away, reform, or pop up elsewhere. That's not a coincidence."

Client: I have noticed some big hedge funds have gotten some very negative press in the past few years. What should I make of that?

We have all heard about the blow-ups at some major hedge funds, including Amaranth and Long Term Capital Management (for more on LTCM, I highly recommend When Genius Failed, by Roger Lowenstein).

Although it is not fair to lump every hedge fund in with the most infamous failures, perhaps some of the extreme cases of hedge fund problems stem from a lack of regulation. Hedge fund managers are not required to have their performance audited or their investment methods independently verified. Until February 2006, hedge funds were not required to register with the SEC and the "requirements" to become a hedge fund manager were not nearly as comprehensive as those governing separate account money managers. In fact, according to the Wall Street Journal, less than 25% of U.S. hedge funds were registered with the SEC as of April 2006**.

Client: So, are hedge funds always a bad investment?

Not always. Like any investment, hedge funds have their place. For large institutions or ultra high net worth investors, a $500,000 or $1,000,000 investment in a hedge fund may be inconsequential. For everyone else, it is always a smart idea to critically evaluate the methodologies and performance of any vehicle before committing their hard earned capital. At the end of the day, if it looks too good to be true, it probably is.

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* Source: Bloomberg, "Hedge Fund Conflicts Still Largely Kept Secret", John F. Wasik
** Source: Wall Street Journal, April 2006

Each week, the Advisor's Corner tackles common situations and issues facing financial advisors and their clients.