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Randall Financial Group News

11-Apr-04

Hedge Funds-Are they for you?

So how’s your investment IQ? Do you know the difference between a stock and a bond? Can you explain how a mutual fund works? What’s riskier, large cap value or small cap growth? These are answers that any investor should be comfortable giving. If you know them then you’ll probably pass investments 101. Now let’s up the level of difficulty. Do you know the difference between absolute and relative return? Can you explain what an equity market neutral strategy is? What’s riskier, fixed income arbitrage or managed futures? These are questions that most investors have never heard but the answers are critically important to investors in hedge funds.

According to The Hedge Fund Association there are more than 5000 hedge funds in existence comprising over $600 billion dollars in invested assets. Hedge funds have long been the tool of institutional investors and the super wealthy. They’ve been associated with famous investors like George Soros and his Quantum fund as well as famous failures like that of Long Term Capital Management and Ivan Boesky. But what are these mysterious and little understood investments? Why have they made the news lately, and do they deserve a place in your portfolio. Read on and we’ll try to answer those very questions.

Hedge funds, like traditional mutual funds, are pooled investments. They take an investors money and co-mingle it with that of other investors to execute a common strategy. Again like mutual funds, these strategies can run the gamut from extremely conservative to highly speculative. Some hedged funds use aggressive trading strategies including borrowing or leverage to increase returns. Other funds are more conservative, taking advantage of momentary price differentials in identical securities for a profit known as arbitrage.

The similarities between a hedge fund and a traditional mutual fund however, end here. Hedge funds and mutual funds differ greatly in two areas. The first is how each type of investment is structured. The second difference is the intent or objective of the manager running the fund.

Mutual funds are structured as open end investment companies. This structure subjects them to strict regulation by the Securities and Exchange Commission. As investment companies, mutual funds are required to meet very strict guidelines in terms of their investment activity. They have specific reporting requirements and are limited with respect to the types of investments and trading strategies they may utilize. Because they are subject to this oversight, the government allows them to market these mutual funds to the general public. As long as they meet certain guidelines, mutual funds can be sold to anyone who has money to invest.

Hedge funds on the other hand are not formed as investment companies but rather as private limited partnerships with the manager of the fund acting as the general partner and often investing a substantial amount of his or her own money. Because they are formed as partnerships, they are virtually unregulated by the federal government. This lack of regulation gives them wide latitude with respect to the types of investments and strategies they can employ. They are free to use leverage or borrowing. And, they often utilize short sales, options and other “derivative” securities to maximize return. It’s this more free wheeling style that has gotten them into the news lately. Some hedge funds like Canary Capital have been taking advantage of traditional mutual funds by rapidly trading in and out of these funds to take advantage of pricing discrepancies. The mutual funds have sometimes encouraged this activity because they make money. This trading, however, can be detrimental to existing share holders.

There is a trade-off for this freedom and lack of oversight. The government does restrict who can actually invest in these funds. Hedge funds are generally available only to either Accredited or Qualified Investors. These investors are defined by the Securities and Exchange Commission as having a net worth of more than $1 million or $1.5 million dollars respectively. In the case of an Accredited Investor, personal annual income over the past two years of $200,000 or more would also qualify. The government feels that this level of net worth is indicative of an experienced investor who requires less protection. Interestingly, over the past decade as portfolio and home values have risen, increasing numbers of main stream investors have become eligible to invest in hedge funds.

The other primary difference between hedge funds and mutual funds is the objective of the manager who runs the fund. While everyone wants to make money, the mutual fund manager pegs his performance to the stock market. This relative performance benchmark means that if the stock market is up 10 percent then the manager is doing well if they’re up 11 percent. By the same token, if the market is down 10 percent, the mutual fund manager is happy if they’re only down 9 percent even though they lost money.

Hedge fund managers view their job a little differently. They seek absolute performance. The hedge fund manager’s goal is to make money in any market environment. That’s not to say they’re always successful but that is their objective. Absolute return means they don’t measure their performance versus the Dow or the S&P or other common bench marks. They typically set their own performance goal such as “10% per year before taxes” and seek to meet that objective each year.

So you may be wondering if hedge funds belong in your portfolio. Well, as always, that depends. First, you need to meet the eligibility requirements discussed earlier. Investment advisors and hedge fund managers are required to screen you prior to giving you information on a particular investment. Hedge funds are not for the novice investor. You should be comfortable with mainstream investments before considering alternatives like hedge funds. Hedge funds do, however, offer one key element to an overall portfolio, which is diversification. Diversification is the practice of combining investments of different types to lower risk and increase return. Because hedge fund performance has a low correlation with the overall stock and bond markets, it can offer attractive diversification to a portfolio concentrated in more conventional investments.

If you think hedge funds might be right for you then do your homework. Be sure you’re familiar with the added risks and restrictions of these investments, many of which are not covered here. Most financial advisors have never used a hedge fund, so if you consult one, be sure they are familiar with alternative investments and can describe how they may or may not be suitable in your situation. Once you’ve mastered these basics, you’ll be ready to pass investments 102!

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