Hedge Funds - Are They Right For You?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
August 8, 2006

IN THIS ISSUE:

1. Hedge Funds Still 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 July 25 issue of the 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 demand for hedge funds remains so high.

Before moving on, let me tell you that there is no way this brief article can fully describe hedge funds or the industry. A visit to Amazon.com, for example, reveals over 100 books written about hedge funds, and this is in addition to tons of information available through magazines, subscription rating services and many other websites on the Internet. My hope is if you are considering investing in hedge funds, you will use the information in this article as a springboard to a deeper investigation into these investment vehicles.

A Popular, Though Misunderstood Investment

For the last several years, hedge funds have been among the most popular alternative investments. This is interesting because hedge funds, like most privately offered investments, are not allowed to advertise, and many investors who think they might 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 with these types of investments.

Though often misunderstood, the demand for hedge funds is exploding. In testimony before the US Senate Committee on Banking, Housing and Urban Affairs on July 25, 2006, SEC Chairman Christopher Cox estimated that there are now over 8,800 active hedge funds with assets in excess of $1.2 trillion, up from a Forbes estimate of only about 600 funds with $38 billion in 1990. These numbers are estimated because exact figures are hard to determine since many hedge funds operate offshore, reporting is voluntary and privately offered 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 increasingly been attributed to the hedge fund industry at large, resulting in hedge funds being the latest “darlings” of the investment industry.

I have long noticed a definite “herd instinct” in relation to investments. If certain types of investments start to be discussed frequently in the financial media, it’s not long before money is flowing into those investments, often without much regard to their suitability. That’s what I have seen happening in the hedge fund industry in the last several years. Demand is so strong that the number of funds and assets under management have exploded over the last 10 years.

This exploding demand is surely one of the main reasons that mutual fund companies are now flocking into hedge-like strategies in an effort to provide the advantages of alternative investments to those who would not otherwise qualify to invest directly in hedge funds.

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 original fund’s strategy of “shorting” certain stocks to offset long positions of companies in similar industries. In today’s parlance, this fund would be known as having a “market neutral” strategy. This fund also used leverage (ie – debt), which continues to be an integral part of many hedge funds today.

In the beginning, most hedge funds utilized the limited partnership for their structure, but today hedge funds use a variety of structures including master trusts, limited liability companies (LLCs), and others. Given the variety of structures, there is still a lot of confusion on the part of investors, and even some Investment Advisors, regarding exactly what is a hedge fund. Obviously, not every limited partnership, LLC 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 often referred to as those that employ “skill-based strategies” due to their reliance upon the skill of the manager to be successful. The “value-added” skill of the manager (if any) is typically referred to as the “alpha,” which is the measurable risk-adjusted return the manager provides in excess of the return 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; hedge funds typically utilize active portfolio management techniques such as long and short trades, leverage, options, derivatives, etc. with a stated objective to provide above-average returns with less risk (but are not always successful at doing so).

Multiple Strategies & Funds of Funds

Unlike the Jones Group’s original 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, 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 more common 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 and others, 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 either by 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 more easily access top-rated managers because they are counted as a single investor (within the 99 investor rule) and can more easily meet multi-million dollar minimums.

The diversification provided by the Fund of Funds doesn’t come without a cost, however. While the risk of investing in a single fund is moderated, a Fund of Funds can also moderate the returns to the investor. Why? Among other things, the Fund of Funds also adds on another layer of fees to an already fee-heavy investment. Higher fees can reduce returns even if the Fund of Funds manager adds value.

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 and/or annual income of at least $200,000 in each of the last two years and an expectation of the 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. TNS Financial Services, a London-based market research organization, estimates that the number of US millionaire households hit 8.9 million in 2005, up 8% from the year before.

Unfortunately, investment knowledge and sophistication do not necessarily come about just because someone’s net worth rises above $1 million or they earn $200,000 in annual income. As a result, many investors who technically qualify as accredited investors are not comfortable with doing (or not willing to do) the serious investigation and due diligence that are recommended before participating in hedge fund investing.

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 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. According to Greenwich-Van Hedge Fund Advisors, its Global Hedge Fund Index has outperformed the average equity mutual fund and the S&P 500 Index over the past 18 years.

However, other hedge fund indexes did not fare as well against the S&P 500 Index, and other studies have shown just the opposite results over different time periods. This underscores how comparisons of different investment strategies can be skewed (positively or negatively) by carefully selecting the right benchmark or the time period over which the comparison takes place.

To be fair, not all hedge funds are designed to “beat the market.” Some are structured simply to limit losses as compared to the market indexes and provide “absolute returns” as I will discuss more below. In 2002, for example, the Global Hedge Fund Index was essentially flat for the year, while the S&P 500 was down over 22%. I think most investors would have been very happy with that result.

Depending upon the strategy employed, many hedge funds have very little correlation with the average stock and bond market investments. In addition, Greenwich-Van’s analysis shows that the performance noted above came with less risk, as measured by standard deviation. However, individual hedge fund strategies, as compared to the index noted above, 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.

Adding hedge funds to a portfolio can also increase the diversification among investment strategies. As I discussed in my June 13, 2006 E-Letter, I think it is important to not only diversify among asset classes such as stocks, bonds and others, but also among various investment strategies such as asset allocation, active management and alternative investments. Hedge funds offer the potential for such diversification.

Hedge funds also offer a higher degree of flexibility in regard to the types of investments employed by the Fund Manager to reach its objectives. Instruments such as options, futures, convertibles, and warrants can all be used by the Fund Manager, in addition to long and short securities trades. Some hedge funds also offer leverage and arbitrage strategies in an effort to enhance returns and/or reduce risks.

Another advantage of hedge funds, in my opinion, is that most have a performance-based fee schedule. The typical hedge fund has a fixed percentage-of-assets management fee, usually 1% - 2% annually, plus an “incentive fee” of 10% to 20% of new 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. But there can be a drawback to this arrangement as I will discuss below.

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.

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. Therefore, it takes considerable due diligence to determine whether the hedge fund manager is really smart or has just been lucky. In other words, do your homework before investing in any hedge fund.
Hedge funds are not highly regulated by the SEC (or other oversight agencies) as are 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.
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 to $5 million or more are common, especially for the more successful 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.
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. As noted above, many of the most successful hedge fund managers require minimums of $5 million or even more.
Even if you are a large investor and can meet the $1+ million minimums, you still may not be able to access the more successful 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 usually not available to US investors.
Hedge funds are not required to report returns monthly, so an investor may only receive information on a quarterly basis (or less often). They may also allow redemptions only once per calendar quarter (or less often). In addition, some hedge funds have “lock-up” provisions that require the investment to stay with the fund for a year or more before any redemption can occur. Don’t expect monthly reporting and redemptions in hedge funds.
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. Even those that invest in public securities often do not disclose their holdings, since providing “transparency” might negatively affect their strategies.

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 fund 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 may have no idea what they are invested in. Thus, if transparency is important to you, hedge funds may not be the best investment alternative.
I noted above how a performance-based fee structure can be an advantage to the hedge fund investor, in that it aligns his interests with those of the Fund Manager. However, the level of fees charged by hedge funds is generally much higher than those found even in actively managed mutual funds. This can be a disadvantage if the Fund Manager is not able to add value over and above this higher fee.

In addition, the performance-based fee structure may cause a Fund Manager to take more risks in an effort to maximize his or her compensation. It is always important to make sure any hedge fund you invest in has a “high water mark,” meaning that incentive fees are not paid until any losses are fully recovered.
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, or they only manage offshore funds, 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 (and now hedge-like mutual funds) using increasingly similar strategies and chasing the same types of trades, the returns on these strategies and trades are likely to narrow (or suffer) over time.

This list of hedge fund drawbacks, and particularly the one just above, is not intended as an indictment of hedge funds in general. As with most investments, there are good hedge funds and there are bad ones. There will continue to be new hedge funds with new and different strategies that produce impressive returns, just as there will be those that disappoint. The key, as I hope I have made clear, is that you need to do your homework and be very clear what you are getting into before you invest.

Conclusions

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 impressive above-market returns, while avoiding much of the pain of the recent bear market. Others, of course, have not enjoyed such success.

With hedge funds, like most investments, due diligence is the key to success. As noted above, 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 leverage, 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 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. Such a decision can only be made on an individual basis after consultation regarding your personal financial situation, experience, objectives, etc.

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. While I do not endorse any of these, my favorite hedge fund websites are:

Greenwich-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.

Best Wishes,

Gary D. Halbert

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