HEDGE FUNDS – ARE THEY RIGHT FOR YOU?
FORECASTS & TRENDS E-LETTER
HEDGE FUNDS – ARE THEY RIGHT FOR YOU?
IN THIS ISSUE:
1. Hedge Funds Are The Rage In Investment Circles.
2. What Are Hedge Funds & How Do They Operate.
3. Why Good Hedge Funds Are Hard To Get Into.
4. Hedge Fund Advantages & Disadvantages.
5. Bottom Line – Do Your Homework Before You Invest.
Introduction - Investing on the Hedge
In my June 24 issue of Forecasts & Trends E-Letter, I discussed some general information about alternative investments. I also said that I would be writing more about the various types of alternative investments over the next few weeks.
In this second installment of the Alternative Investment series, I will discuss one of the most popular forms of alternative investments – hedge funds. We will discuss the basic characteristics of these funds, how they are generally structured, how they work (and sometimes don’t work), advantages and disadvantages of investing in them and why the current demand for hedge funds is so high.
Before moving on, let me tell you that there is no way this brief article can fully describe the hedge fund industry. A visit to the Amazon.com website reveals no less than 52 books written about hedge funds, and this is in addition to tons of information available through magazines, subscription rating services and on the Internet. My hope is that you use this information as a springboard to a deeper investigation of these funds before deciding to invest.
A Popular, Though Misunderstood Investment
Hedge funds are currently one of the most popular of the alternative investments. This is interesting because hedge funds are not allowed to advertise, and many investors who think they would like to invest in a hedge fund have no idea exactly what hedge funds are or what they do. Furthermore, many investors do not understand the different way in which most hedge funds are regulated, the limitations on entry and exit inherent in most of these funds and, most of all, the unique risk factors that are involved.
Though often misunderstood, the demand for hedge funds is exploding. According to recent SEC testimony, there are between 6,000 and 7,000 active hedge funds in the U.S. with approximately $650 billion in assets, up from a Forbes estimate of only about 600 funds with $38 billion in 1990. This does not include thousands of offshore hedge funds. Numbers are estimated because exact figures are hard to come by since reporting is voluntary, and most hedge funds do not have to register with the SEC.
However, it is easy to see that interest in hedge funds is fueling a lot of growth in the industry. Part of this growth can be attributed to the ability of certain hedge fund managers to consistently beat the stock market indexes, sometimes with less risk. However, I’m afraid that the success of these relatively few individual fund managers has now been attributed to the entire hedge fund industry, resulting in hedge funds being the latest “darlings” of the investment industry.
The interest in hedge funds has even infected the mutual fund industry. Rydex Funds and Standard & Poors have just recently announced a publicly available product that seeks to emulate an index of hedge funds. How this latest hedge fund “knock-off” is going to work (if it does) is not at all clear to me yet. In addition, there are many mutual funds that have now incorporated both leverage and short trading in an effort to look more like hedge funds and make money in any kind of market. Time will tell whether or not these recent arrivals to the hedge fund arena will be successful, and until actual results can prove their merit, I would avoid investing in them.
While there are still significant differences between hedge funds and mutual funds, I expect to see more blurring of the lines separating the two in the future. In this article, I will stick to a discussion of traditional hedge funds, and possibly cover these newer “hybrids” in a future issue.
Hedge Fund Basics
The first hedge fund was started by the A.W. Jones Group in 1949. The nickname “hedge fund” was derived from the fund’s strategy of shorting certain stocks to offset long positions of companies in similar industries. This fund also used leverage, which continues to be an integral part of hedge funds today. In today’s parlance, this fund would be known as having a “market neutral” strategy.
In the beginning, hedge funds utilized the limited partnership for their structure, but today some funds are formed as master trusts. However, there is still a lot of confusion on the part of investors, and even some Investment Advisors, because there is no industry-wide definition of exactly what is a hedge fund. Not every limited partnership or master trust is a hedge fund.
In fact, the term “hedge fund” is somewhat misleading, since many of today’s funds that are identified as hedge funds do not employ any hedging strategies at all. For this reason, hedge funds are sometimes referred to as “skill-based strategies” due to their reliance upon the skill of the manager to be successful. The skill of the manager is measured in terms of “alpha,” which is the measurable risk-adjusted return the manager provides in excess of the underlying market sector. A high alpha means that the manager is adding considerable value (in terms of profits) over and above the comparable market index (such as the S&P 500 or other appropriate market benchmark).
Thus, my personal definition of a hedge fund is: a private investment program that is dependent upon the unique skills and/or systems of a manager who is compensated via a performance-based fee schedule; managers typically utilize active portfolio management techniques such as long and short trades, leverage, options, derivatives, etc. in an effort to provide above-average returns with less risk (and not always successful at doing so).
Multiple Strategies and Funds of Funds
Unlike the Jones Group’s basic market neutral concept, hedge funds today employ a wide variety of strategies (also called “styles”), some with no hedging component whatsoever. If you research hedge funds on the Internet, you’ll find strategies with names like Merger and Convertible Arbitrage, Event-Driven, Opportunistic, and Long/Short, just to name a few.
Unfortunately, investors are sometimes confused when researching hedge funds because virtually every source of hedge fund information has a different set of hedge fund strategy definitions. Space does not permit me to analyze each and every hedge fund style in this article, but later on I will provide a link to a more detailed description of the various strategies.
As I discussed above, hedge fund investors depend upon the skills of the fund manager when they invest. However, this leads to a couple of potential problems. If the manager is highly successful, investors may not be able to access the manager unless they have millions to invest. A second potential problem is what happens to the hedge fund if the manager suddenly quits, retires, or dies, or if the manager’s methodology suddenly loses favor in the current market?
To help address these issues, the “Fund of Funds” was created. Just as the name implies, a Fund of Funds is a hedge fund that invests in other hedge funds. Diversification can be attained by either investing in hedge funds with different strategies, or with multiple hedge funds of the same strategy.
In either case, this diversification helps to minimize the effects of the loss of the manager in a single hedge fund. In addition, Funds of Funds can access top-rated managers because they are counted as a single investor and can more easily meet multi-million dollar minimums.
The diversification provided by the Fund of Funds doesn’t come without a cost. While the risk of investing in a single fund is moderated, a Fund of Funds can also moderate the returns to the investor. The Fund of Funds also adds on another layer of fees to an already fee-heavy investment.
The Potential Market For Hedge Funds
Another reason that hedge funds have become so popular is that there has been a big increase in the number of investors eligible to invest in them . In 1982, the SEC created “Regulation D” as an exemption from registration for certain types of private securities (i.e. - hedge funds) sold only to sophisticated (read “wealthy”) investors. The SEC called these individuals “accredited investors.” While there are several qualification tests, an accredited investor is generally someone who has a net worth of more than $1 million or annual income of at least $200,000 in each of the last two years and expectation of same in the current year.
In 1982 when the accredited investor rule was enacted, there were far fewer millionaires and high-income executives than there are today. Since the accredited investor net worth test allows you to include your home, ever-increasing real estate prices have pushed many people into the status of being millionaires. It is estimated that there are 7-8 million millionaires in the US today, up approximately 44% since 1995.
Unfortunately, investment knowledge and sophistication don’t come about just because someone’s net worth rises above $1 million or $200,000 in annual income. As a result, many investors who technically qualify as accredited investors are not capable (or not willing) to do the necessary investigation and due diligence that is necessary to participate in hedge fund investing. I will write more about this in a future E-Letter.
If you have reached this point in the article and are discouraged because you are not a wealthy investor, don’t despair. Read on to discover more about the active management strategies employed in hedge funds, and then in the Conclusion section I will tell you how you, too, can access many of these strategies without having to meet the million dollar minimums or higher.
Hedge Fund Advantages
For many wealthy investors who can afford the large up-front minimums, carefully selected hedge funds can make a lot of sense. A big reason for this is that certain hedge funds provide the investor with access to specialized investment strategies not available elsewhere and the potential for positive returns, generally, under most any kind of market environment.
Depending upon the strategy employed, many hedge funds have very little correlation with the average stock and bond market investments. All hedge funds are not necessarily designed to “beat the market;” some are structured to limit losses as compared to the market indexes and provide a smoother ride.
According to the Van Hedge Fund Advisors website ( http://www.vanhedge.com), the average performance of the hedge funds they track has outperformed the average equity mutual fund and the S&P 500 Index over the past 15 years. In 2002, for example, the average U.S. hedge fund was essentially flat for the year, while the S&P 500 was down over 22%.
In addition, Van’s analysis shows that this performance came with less risk, as measured by standard deviation and its proprietary “Van Ratio.” However, individual hedge fund strategies have varying levels of risk, so an individual fund may have a much greater risk than the average of all the funds.
Another advantage of hedge funds is that they are not limited by the same rules that apply to mutual funds, such as the requirement to limit any individual stock to no more than 10% of the total portfolio – the “concentration” issue. Of course, this concentration can also have a negative effect if the hedge fund manager makes a large bet on a single holding and it decreases in value.
To me, one of the primary advantages of hedge funds is that they have a performance-based fee schedule. The typical hedge fund has a fixed percentage-of-assets fee, usually 1% - 2% annually, plus an incentive fee of 10% to 20% of profits. This means that the goals of the manager and the investor are aligned, since the manager makes much more if his fund is profitable.
Hedge Fund Drawbacks
As with any type of investment, there are disadvantages as well as benefits to including hedge funds in your portfolio. Here are some of the potential disadvantages of hedge funds.
1. As noted above, hedge funds have also been called “ skill-based strategies,” in that they depend upon the abilities of a fund manager to add value that merits the higher level of fees charged and risks incurred. However, it takes considerable due diligence to determine whether the hedge fund manager is smart or has just been lucky. In other words, do your homework before investing in any hedge fund.
2. Hedge funds are not as highly regulated by the SEC (or other oversight agencies) as most other publicly offered securities. While some consider this an advantage, it is also a disadvantage in that less sophisticated investors do not always realize that there is a greater risk of fraud in a private placement than in a public offering, generally speaking. This is another reason to do your homework before investing.
The SEC and NASD are also starting to push for more regulation of hedge funds, which could be a boost to investors, but could also have the effect of pushing more successful managers to move to offshore funds where regulation is less onerous.
3. Only 99 investors can participate in any single hedge fund if the manager wants to maintain the regulatory exemption. This means two things. First, minimums for hedge funds are high in order to produce a large enough fund to make it worth the manager’s time. Minimums as low as $100,000 are rare, while minimums of $1 million or more are common, especially for the best managers.
Second, this means that once you find out about a good fund, you may be too late to invest if the 99 available slots have already been taken. Even worse, some hedge fund managers will “bump” a smaller investor out of the fund in order to make a slot for a larger investor.
4. Because of the private nature of hedge fund investments, and the limitation on the number of investors, it is very difficult to access managers with successful long-term track records for less than $1 million. In fact, many of the most successful hedge fund managers require minimums of $5 million or even more.
5. Even if you are a large investor and can meet the $1+ million minimums, you still may not be able to access the best managers as they may only operate offshore funds. Many talented managers have chosen to operate funds offshore where the regulatory framework is more favorable. These funds are not usually available to US investors.
6. Hedge funds are not required to report returns monthly, so an investor may only receive information on a quarterly basis. They may also allow redemptions only once per calendar quarter. In fact, some hedge funds have “lock-up” provisions that require the investment to stay with the manager for a year or more before redemption can occur. Don’t expect monthly reporting and redemptions in hedge funds.
7. Some hedge funds invest in private securities offerings and other investments that are difficult to value accurately, so the actual value of the investment may be more or less than is represented on the periodic statement.
Related to this is the matter of “transparency,” or the ability to see the individual investments making up the fund’s portfolio. Since hedge fund managers usually try to take advantage of inefficiencies in the market, they do not like to publish all of their positions for fear that other hedge funds managers will use this information to trade against them. It is very important to know, going in, if the hedge fund will show you their particular investments in their periodic reporting, or not. Many don’t and you will have no idea what they are invested in.
8. While hedge funds seek to reduce volatility and risk, there is no guarantee that they will do so. Since many of the most successful managers are unavailable because of the 99 investor rule, or sky-high minimum investments, many investors are putting their money with managers who have limited experience in managing hedge funds. In the wrong hands, the use of short trades and leverage can lead to high volatility and large losses, just the opposite of what investors wanted to achieve.
The above discussion of advantages and disadvantages of hedge funds is not exhaustive. The issues I have raised, as well as others, can be found in numerous books and other articles about hedge funds. However, I would like to add one of my own caveats to the list concerning the proliferation of the number of hedge funds. Please read the following carefully.
Since many hedge fund managers try to take advantage of temporary market inefficiencies, the rapid increase in funds means more and more fund managers are trying to do the same things. With more managers chasing the same types of trades, the returns on these trades are likely to suffer over time. Returns could suffer as a result.
I am also concerned about the mutual fund industry’s attempts to mimic hedge funds with new products. As noted earlier, there are already mutual funds that use leverage and employ both long and short trades, something unheard of just a few years ago. If the use of these hedge fund techniques in mutual funds becomes more mainstream in the industry, I fear that the ramifications for the securities markets could be huge – meaning returns could fall.
Hedge funds represent another diversification opportunity for those investors who are sophisticated enough to investigate them thoroughly before investing, and wealthy enough to meet the high minimum investment requirements. The record is clear that some of these funds have been able to deliver above-market returns, while avoiding much of the pain of the recent bear market.
However, as with any investment, due diligence is the key to success. If you are interested in participating in a hedge fund, you need to do your homework. You not only need to become familiar with the hedge fund terminology, but also with the various advanced trading strategies employed by different types of managers such as the use of derivatives, options, short trades, etc.
As a practical matter, hedge funds are out of reach for most investors, but this doesn’t mean that the average investor cannot access active management strategies similar to those employed by hedge fund managers. As I noted above, the mutual fund industry is already starting to roll out funds that are touted to emulate hedge funds. While I continue to urge caution on these relatively new entrants into active management, at some point the cream will rise to the top and, hopefully, there will be some successful hedge fund-type strategies that will be available to the average investor.
For those not willing (or able) to take on hedge fund risks, there are many professional money managers who have used active management techniques for many years for both individual stocks and mutual funds, including the money managers we recommend at my company. Unfortunately, there is no single database or website that contains all of the names of these Advisors and the strategies they employ. Those partial databases that do exist are usually very expensive to obtain.
There are, however, investment advisory firms that do have access to these various databases and can introduce average investors to successful money managers. My company, ProFutures Capital Management, is such a firm, and we have clients all across America. For others, you can go to the Investment Management Consultant Association (IMCA) website at http://www.imca.org.
In closing, let me say that I am not recommending that you invest in hedge funds, even if you are a sophisticated, accredited investor. This E-Letter is simply meant to give you a better understanding of these types of investments. Hedge funds carry a high degree of risk; liquidity is limited; and they usually employ leverage and the use of derivatives. Anyone considering a hedge fund should carefully determine if they are suitable for such an investment. And don’t forget, past results are not necessarily indicative of future results.
Additional Hedge Fund Information
As I discussed earlier, there are many different descriptions of the various hedge fund strategies, and different sources of information sometimes have different names for the same type of fund. To help avoid confusion, I have compiled a list of hedge fund strategy descriptions that are most common in the industry. CLICK HERE to review my list of hedge fund strategies.
For more information about hedge funds, you can turn to one of the many books that have been written on the subject. My favorite is still the 1995 book entitled “Hedge Funds” by Jess Lederman and Robert A. Klein.
There are also many sources of hedge fund information on the Internet. However, you have to be careful when doing a search because many of the websites are out to sell you something. My favorite hedge fund websites are:
Van Hedge Fund Advisors – http://www.vanhedge.com
Managed Accounts Reports – http://www.marhedge.com
Alternative Investment Management Association – http://www.aima.org
I will stop now, for this week. I hope this has been helpful. Maybe I have raised more questions than answers, but that is not a bad thing. If I have given you more questions to ask (or think about), that is a good thing. I will have more to say in upcoming issues in this Alternative Investments series.
Gary D. Halbert
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.