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Hedge Funds: Protection Against An Aging Bull

by Dion Friedland, Chairman, Magnum Funds

        Last July, when technology stocks took a beating, Raj Rajaratnam wasn’t fazed. Adding to his short investments just before the downturn, Rajaratnam, manager of the technology-intensive Galleon Omni Fund, not only cushioned the fund against a precipitous fall, he positioned it to squeak out a modest, 2.2 percent gain.

        What Rajaratnam did was hedge – cover his downside, minimize his risk – in the interest of steady, consistent returns. It’s a strategy that more and more fund managers are taking – and more of their clients demanding – as stock markets reach valuations that many investors would agree are overheated.

        Ironically, most mutual funds, the darlings of the investment world, cannot take short positions or use put options. "Hedge" funds, on the other hand, can do this and more, with the flexibility not only to be defensive but to be responsive and opportunistic in its investments.

        The reason: Hedge funds, unlike most conventional funds, aren’t limited to a single asset class such as stocks. Within the hedge fund universe there are a wide variety of funds with a wide range of strategies and styles. Some may invest in asset classes such as currencies or distressed securities and in one or more regions throughout the globe. Some utilize return-enhancing tools such as leverage, derivatives, arbitrage, and highly concentrated positions that are generally beyond the reach of mutual funds, which are subject to regulations and disclosure requirements.

        According to a study by Van Hedge Fund Advisors, Inc., assisted by the faculty of Vanderbilt University’s Owen Graduate School of Management, global hedge funds achieved higher returns than mutual funds with lower risk of loss when risk was measured similarly for both hedge funds and mutual funds. The study looked at more than 1,600 hedge funds for five years ending December, 1995. Furthermore, over that five-year period, almost all hedge fund styles earned significant excess returns compared to mutual funds with less risk of loss.

        Hedge funds are especially effective in sudden bear markets. In 1987, the year of the crash, while the Standard & Poor’s 500-stock index rose 5.24 percent and growth mutual funds only 1.02 percent, hedge funds returned 14.49 percent. Again, in 1990, when the S&P and equity growth mutual funds registered returns of 3.11 percent and 3.82 percent, respectively, hedge funds finished the year up 10.97 percent.

        The strong results can be linked to performance incentives in addition to investment flexibility. Unlike many mutual fund managers, hedge fund managers are usually heavily invested in a significant portion of their funds and share the rewards as well as risks with the investors. An "incentive fee" remunerates hedge fund managers only when returns are positive, whereas mutual funds pay their financial managers according to the volume of assets attracted, regardless of performance. This incentive fee structure tends to attract many of Wall Street’s best practitioners to the hedge fund industry.

        How can one invest in a hedge fund? In general, funds accepting new investors are open on a monthly or quarterly basis. Unless an individual has a great deal of money to invest and an understanding of the risks associated with the different hedge fund strategies, the best approach is to either use a consultant or invest in a fund of funds. A funds of funds spreads its portfolio among a diversified mix of hedge funds, blending different strategies and asset classes which can provide a more stable long-term investment return than that of the individual hedge funds.

        This approach is especially useful given the broad range of hedge fund strategies and styles that can confound the lay person. Although hedge funds got their name in the early 1960s with managers who both bought stocks and sold them short, today the term refers essentially to any fund using alternative investment styles, some of which may not even hedge risk.

        Their numbers are increasing rapidly. During the past few years, the number of hedge funds has risen by about 20 percent per year and the rate of growth in hedge fund assets has been even more rapid. Currently, there are estimated to be 4,000-5,000 hedge funds managing $200-$300 billion. While the number and size of hedge funds are small relative to mutual funds, their growth reflects the importance of this alternative investment category for institutional investors and wealthy individual investors.

 

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