The current vogue for hedge funds has caused this once arcane corner of the investment world to grow exponentially, doubling its assets under management in the last five years to about $1.4 trillion spread among 9,200 funds. Hedge funds once required you to be rich and put up big bucks to get in. Due to these constraints, participation in hedge funds has been largely limited to institutions and “accredited investors,” otherwise known as the wealthy.
After the three-year bear market of 2000-2002, investors were looking for ways to avoid repeating their mistakes, which led some to lose upwards of 80% of the value of the stocks they owned. The investment banking industry listened to what the investors were asking for and figured out a way to market a long-short strategy in hedge funds and make it available to the average investor. The pitch was simple: we make money in both up and down markets by having part of your portfolio invested in long equities (makes money in up markets) and part of your money will be used to short stocks (makes money if the stock market goes down). Then they add leverage (borrowed money) to magnify the return on your portfolio. Sounds great!
Next, they figured out a way to drop the minimum investment from $1 million to $50,000, so more folks could participate. Suddenly, mere mortals with modest sums could act like big-league investors. A problem, though, is that big-league investors can afford to lose $1 million without losing any sleep. Joe Investor, who puts up his $50,000 in one fund, can’t afford to do the same.
Because they’re unregulated, hedge funds can pursue all kinds of strategies that are off limits to conventional mutual funds (and for good reason). These private pools of capital are basically limited partnerships. The money manager is usually the general partner and investors are the limited partners. You might expect that the word “hedge” might imply caution, but the reality is that the typical hedge fund employs strategies that entail a wide variety of risk.
Some of the more common risks associated with hedge funds are, but not limited to:
1. Lack of transparency: You don’t know what you are invested in. The following headline appeared in the Financial Times on Monday, April 2, 2007: Hedge Funds Lead U.S. Junk Sector Lending. “Three quarters of loans to junk-rated U.S. companies are now provided by hedge funds and other non-banks.” And they use leverage to lend money to junk-rated companies. It’s an accident waiting to happen.
2. You don’t know how the historical returns were calculated: What method was used to calculate the returns? Are the returns net of all fees? For un-priced securities in the portfolio, who made the valuation and what method was used to define the value used in calculating the historical returns?
3. Lack of disclosure: You don’t know who has side deals in the fund. You may be a second class investor and not know it.
4. Lack of liquidity: With ordinary mutual funds, investors have daily access to the net asset value of their shares on a daily basis. But hedge fund investors may face significantly longer periods during which they are denied access to their money, in some cases, up to two or more years.
5. Steep fees: Generally 2% annually on assets under management and 20% of profits (hedge funds, however, do not share in your losses). That’s why it’s often said the best way to benefit from a hedge fund is to run one.
6. Lackluster performance: Analysis has demonstrated that, because of high fees and other cost factors, it’s unlikely investors will improve their long-term performance by putting money into hedge funds. Also, hedge funds are a prime example of a lot of money chasing very few ideas.
7. Assuming unacceptable risk: High risk is a component of high return to justify outrageous fees. Hedge funds need to produce returns of 18% to 20% to give the limited partner a 10% return.
8. Lack of diversification: Because they are making large, focused bets in their hope to outperform and justify their fees.
9. Potential loss of capital: Hedge funds blow up. Remember Long Term Capital with two Nobel Prize winners on their board as well as, more recently, the $9 billion Amaranth Advisors.
10. Leverage: Some times as high as eight times their capital. One wrong investment decision can make your money evaporate faster than you can say derivative.
11. Complex securities: Hedge funds are fond of investing in complex, illiquid or opaque investments (such as derivatives, options and futures) and investment strategies (such as short selling, betting on currencies) that are not fully disclosed.
12. Complex tax issues: Your accountant will just love you during tax season. You’re going to fund his or her summer vacation. In general, hedge funds tend to be tax-inefficient because of high levels of trading that rack up lots of taxable capital gains, not to mention the K-1 form, that you’ll need before filing your tax returns but will not receive until late in the tax season.
13. Hedge funds are focused on numbers, not people: Your goals and time horizon are irrelevant to hedge fund managers. They are also indifferent to your tolerance for risk.
14. Do you know your hedge fund manager? That manager may have recently closed a failed fund or may have run afoul of regulatory authorities. In a setback for investors, an S.E.C. rule that would have forced most hedge funds to disclose the names and any criminal records of those running the fund was struck down by a Federal Appeals Court last year. In fact, hedge fund managers don’t have to be registered investment advisors.
15. Requires expert due diligence: Don’t try this at home! You need expert help in performing due diligence on a hedge fund. And even then, because hedge funds are largely unregulated and lack transparency, an expert can get it wrong after performing thorough due diligence.
Now that you know about the common risks associated with hedge funds, what can the average – but practical – investor do to achieve the performance necessary to meet their long-term financial objectives?
Three Steps to Success
If you feel confident that your portfolio will meet your expectations of generating reasonable returns that meet your time horizon and tolerance for risk and let you sleep well at night, then follow these three steps:
1. Construct a portfolio that is right for you: Allocating assets in a balanced way among stocks, bonds and cash is a starting point. The point of diversification is to avoid having all your eggs in one basket.
2. Use mutual funds: Employ a mix of diversified and focused funds in your portfolio and avoid hedge funds. The benefits include:
> Full disclosure
> Full transparency
> A public track record
> Regulation by the Securities and Exchange Commission
> Lower fees
> A smaller potential for loss due to diversification, lower fees and asset
> Little or no leverage, lowering your portfolio’s risk.
> Avoidance of major tax issues
> And, generally, improved potential of realizing your goals
3. Seek professional advice: Enlist the help of an experienced advisor to construct and manage your portfolio. A mutual fund manager will not know you, but your advisor will. He or she will know your needs, tolerance for risk and the time horizon you have established for your investments. A professional advisor who acts as your fiduciary will not select investments that are unsuitable to your situation. Today, there are mutual funds that use strategies that may be similar or identical to those of hedge funds – but without all the negatives.
The current fad for hedge funds has increased concern at the S.E.C. about unqualified folks who lack the sophistication to identify and analyze the high-stakes stratagems that characterize hedge fund investing. Accordingly, the commission proposed new rules last December that would require investable assets of $2.5 million – assets in stocks or bonds or real estate, as long as the real estate is an investment property, not your primary residence – for hedge fund investors. The current rule requires a net worth of $1 million, including the value of your primary residence, or two consecutive years of income of $200,000 (or $300,000 for a couple’s combined income). In 1982, when the $1 million accredited investment threshold was defined, 1.87% of American households qualified. By 2006, largely due to the appreciation of real estate assets, 8.47% of American households could invest in hedge funds. Under the proposed standard, eligibility will shrink back to 1.3% of households.
You May Get What You Wished For, But Not What You Expected
While it’s useful to highlight the issues associated with hedge funds, it also serves to underscore the challenges for ordinary investors, who may be tempted from time to time to allow emotion to cloud their judgment. The investment community understands this and creates products that appeal to those emotions, but it’s doubtful these products will provide any meaningful contribution to your investment objectives. They are usually pricey and risky, and stand very little chance of delivering on the promises made in the sales pitch. So as always, do your homework and exercise a healthy degree of skepticism. As the well-worn saying goes, “If it’s too good to be true, it probably is.”