Hedge Funds – Are Hedge Funds For You?

By David R. Friedland, President of the Hedge Fund Association and President of Magnum U.S. Investments, Inc.

“Unregulated pools of capital with high fees that are only available to those who have the stomach to withstand high volatility and who can afford to lose the entire investment.”  This is the false, single-dimensional portrayal of hedge funds that has historically been perpetuated by the media and less informed participants in the financial industry who may see hedge funds as a threat to their livelihood.  As a result, many investors are misinformed about hedge funds and have a negative perception about what this investment alternative really is, and what it can do for them. Nonetheless, hedge funds have continued to grow in popularity, and are now the investment of choice for most sophisticated pension funds, endowments, family offices and high net worth individuals. Should you be investing in hedge funds? This article may help you better decide.

A hedge fund is a term commonly used to describe any fund that charges performance fees and that isn't a conventional investment fund that is, any fund using a strategy or set of strategies other than only investing long in shares (unit trusts/mutual funds), bonds, money markets (money market funds), real estate, venture capital or LBOs (leveraged buy-outs).  Hedge fund strategies, also referred to as alternative investment strategies, include selling stocks short, various arbitrage strategies, hedging against market downturns by short selling or by using options, investing in asset classes such as currencies or distressed securities, and utilizing return-enhancing tools such as leverage, derivatives, and arbitrage.

There are over 9,000 hedge funds in the world today, though the general investing public probably has only heard of very few of them. Regulatory restrictions and a ban on hedge funds advertising, attempt to keep unsophisticated investors away from investing in hedge funds.  Even though many hedge fund managers have registered with the SEC as registered investment advisers, hedge funds continue to be managed in a largely regulatory free environment. This lack of regulation gives hedge funds defensive and opportunistic flexibilities that mutual funds, which are subject to strict regulatory control and disclosure requirements, generally don’t enjoy. Despite the fact that there is no formal regulation stipulating what hedge funds can and cannot invest in, most hedge funds do manage their funds within written mandates, and generally keep their investments and strategy within an area of specialization. This is predicated by the many sophisticated investors - institutional, individual or funds of funds, that demand that hedge fund managers invest within their mandate, as specified in the hedge fund’s offering memorandum.   For example, if our company, a manager of funds of hedge funds, were to find a market neutral fund manager suddenly making unusual returns due to large directional exposure in the equity market, we would redeem our investment because we have other specialist managers, who take a directional view on the equity market, that we have selected for their skill in that area. Investors can also take comfort in the fact that the vast majority of hedge funds are audited, are administered by an independent administrator, and have their assets held by a reputable custodian bank or prime broker.

While media stories about hedge funds in the past have usually focused on funds generating exciting returns, the vast majority of hedge funds make consistency and stability of return, rather than magnitude, their primary goal.

Historical data indicates that a diversified portfolio of hedge funds generates more consistent returns than mutual funds/unit trusts. Hedge funds, unlike unit trusts and mutual funds, have the ability to make money in both up and down markets through the use of derivatives, short selling and other strategies not available to traditional unit trusts.  During the bear market of 2001 and 2002, hedge funds, unlike other long only investments, were able to offer investors an asset class that preserved capital, and in many instances appreciated. This, in contrast to unit trusts and mutual funds, that experienced losses in line with, and often even greater than those suffered in equity markets.

Hedge funds were able to preserve and grow capital during 2001 and 2002 because many hedge funds, as the term implies, "hedge their bets”. They may sell shares short to cover themselves against a drop in stock prices. They may buy put options, which give them the right to sell stocks at a specified future price, in order to lock in a sell price in the event of a severe market drop. They may buy interest-paying bonds or trade claims of companies undergoing reorganization, bankruptcy, or some other corporate restructuring, counting on events in a company, rather than more random macro trends, to affect their investment.

By the same token, these defensive strategies tend to cause hedge funds to under-perform unit trusts and mutual funds in bull markets. However, with the bear market of 2001 and 2002, and more recently the equity market collapse in 2008 still fresh in investors’ minds, many investors have turned to hedge funds to help preserve their wealth, and perhaps you should too.

There are a variety of strategies for investors to consider. The more conservative of these strategies are generally not correlated to equity markets, and deliver steady profits with low volatility.

More aggressive hedge funds that seek high returns, albeit with higher volatility, are also available. These strategies generally have a directional bias to the market, either long or short (long/short equity), or may seek to speculate on future market moves in equity markets, currency markets and bond markets (global macro funds). Aggressive funds have the potential to enjoy large gains, but can also be susceptible to volatile returns. 

The broad range of hedge fund strategies and the many complex styles available, can confuse the average investor. Unless investors have a real understanding of the characteristics and risks associated with the different hedge fund strategies, the best approach for investing in hedge funds is to use a consultant, well versed in hedge fund strategies, or to invest in an established fund of hedge funds.

A fund of hedge funds is a diversified portfolio of hedge funds that allows investors to access a variety of hedge funds with a relatively small investment. Typically, the minimum investment in a hedge fund ranges anywhere from $250,000 to $5 million, whereas the average minimum investment into a fund of hedge funds ranges from $50,000 to $250,000. 

Further, by investing in a fund of hedge funds, investors are able to access a wide range of different hedge fund strategies, providing wide diversification often with exposure to a variety of markets, with one easy to administer investment. 

As a result of this added diversification, funds of hedge funds are often able to provide more consistent returns than individual hedge funds.  Consequently, funds of hedge funds are ideal investment vehicles for investors seeking stable returns, who do not have the time, expertise or resources to analyze, identify and monitor the hedge funds most suitable for their portfolio.

If you prefer to select individual hedge funds yourself, as opposed to investing in a fund of hedge funds, the following are some important tips:

·         First, always understand what strategy the fund manager follows. If the fund manager is unwilling to provide the level of transparency that allows you to completely understand their strategy, and if the fund manager refuses, when asked, to disclose the fund’s largest holdings and exposure, do not invest.

You can also help avoid fraud by performing extensive due diligence on a manager, including background tests – check out the manager’s academic claims. However, this can be very time consuming and difficult to accomplish for an individual. If any discrepancies are found, they should require further follow up.

·         A visit to a fund manager’s office can also be beneficial. Is the back office in good order? Are there checks and balances in place that make fraud less likely?  A first-hand look may detect signs that either confirm or raise concerns about your choice of hedge fund manager.

·         Verify all statements made by the fund manager, especially those made in the offering document to lure investors. Contact the administrator, prime broker, auditor and custodian to ensure that they have, in fact, been employed by the fund.

·          When looking at past performance numbers, verify if they are audited. An unknown small audit firm is undesirable.

·         Diversify, across both the number of hedge fund managers and style and strategies employed by the various hedge funds.

·         If you cannot accomplish the above minimum requirements on your own, you should not invest directly in hedge funds. Rather invest through a fund of funds that has a long history in the business.

The recent multi-billion loss suffered by feeder funds and other funds that invested with Bernie Madoff should not scare you away from investing in hedge funds. These funds failed to do adequate due diligence. Any reasonable due diligence would have raised sufficient cause for alarm not to invest with Madoff. The Madoff example emphasizes the importance of having an adequate understanding of what the fund strategy is, what the major risks of the strategy are, and the need to be adequately diversified.

If this sounds too onerous to perform prior to investing in a hedge fund, be sure to use a consultant to assist you in your choice or invest in an established fund of hedge funds.  Well-established funds of hedge funds and competent consultants, can provide these services for you. They dedicate themselves to understanding the vast array of hedge fund strategies, they identify the leading managers who implement these strategies most effectively, and perform extensive due diligence.

So, next time you hear that hedge funds are unregulated pools of capital that are only available to those who have the stomach to withstand high volatility and who can afford to lose the entire investment, you’ll know better.  You may even know enough to invest in one.