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
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