What's a hedge fund, anyway?

This once-taboo investment vehicle could help you make money in this dismal market—if you can afford the price of admission and stomach the risk.

By Leslie Kane
Senior Editor

Hedge funds are like the ugly ducklings that turned into swans.

Once shunned as secretive, wildly risky, and only for well-heeled high flyers, hedge funds have been attracting new money like a lottery winner attracts long-lost relatives. TASS Research, an alternative investment information and research company in Rye, NY, estimates that these funds, which currently number more than 6,000, took in more than $31 billion in new money in 2001—up from $8 billion the year before.

What exactly are hedge funds? They're privately offered investments that use a variety of nontraditional strategies to try to offset investment risk, an approach known as—you guessed it—hedging. One such technique is short selling: Fund managers identify a stock whose price is likely to decline, borrow shares from someone else who owns them, sell the shares, then make money by replacing the borrowed shares later with others bought at a much lower price—that is, assuming the stock's price actually falls. Hedge fund managers also invest in derivatives, options, futures, and other relatively obscure or sophisticated vehicles. Generally, hedge funds are limited partnerships or limited liability companies, and they can have no more than 500 investors each.

Why the growing interest in these investments? Because they may hold the key to consistent returns, even in this do-nothing market.

"People invest in hedge funds not to get rich, but to stay rich," says Thomas Zucosky, senior vice president of InvestorForce, an investment information and technology company in Wayne, PA. "Some hedge funds have spectacular returns, but what attracts most investors is that the funds can bring steady, positive returns in any market." Through May, for instance, the CSFB/Tremont Hedge Fund Index, which follows about 390 funds, outperformed the Standard & Poor's 500 Stock Index by 22.8 percentage points over one year and an average of 18.9 percentage points over three years.

Just as impressive, it did so with less volatility. The annualized standard deviation, which measures how much returns vary, was just 9.1 percent for the CSFB/Tremont Hedge Fund Index, compared with 15.7 percent for the S&P 500.

There's just one catch: Most hedge funds require a minimum investment of $1 million.

Don't gulp just yet, however. These days, you can choose from several "lite" hedge funds that have more affordable minimum investments (details on those later). Moreover, hedge funds are becoming more mainstream: American Express Private Bank, Merrill Lynch, and Wells Fargo all now offer their own funds, for instance. So not only are you apt to hear more about them, you may be invited to invest in one. That's why it behooves you to understand the basics.

How hedge funds differ from mutual funds

"Traditional mutual funds generally rely on the stock market going up; managers buy a stock because they believe its price will increase," says Jeff Joseph, managing director of HedgeWorld (www.hedgeworld.com), an investment company and global provider of hedge fund information. "With hedge funds, it doesn't matter whether the market goes up or down. Managers can make money regardless of the direction of the broader market.

"Most mutual fund managers attempt to beat a particular benchmark, such as the S&P 500," adds Joseph. "Hedge fund managers don't care about market benchmarks. They aim for absolute returns—a certain percentage return, year in and year out, regardless of how well the market does."

Since hedge funds don't necessarily track the market, they protect your portfolio. "The goal of diversification is to own vehicles that don't correlate with market movements," says Daniel Strachman, managing director of Answers & Co., a New York City money management and marketing firm. "Hedge funds are helpful for managing risk over the long term," notes Richard R. Lee Jr., a financial adviser with Lee Financial in Dallas. "By nature, they offer a hedge against market declines."

Hedge fund managers also often have a stronger personal stake than mutual fund managers. "They usually invest heavily in the fund, sometimes putting in most of their liquid net worth," says Zucosky.

Another crucial difference—and a sticking point for many investors—is that the SEC doesn't dictate strict rules for hedge funds, as it does for traditional mutual funds. Sponsors can manage the fund and make up the portfolio any way they want, and they needn't provide information about holdings and performance. In addition, no rules govern pricing, so investors may be unable to determine the value of their investment at any particular time.

Hedge funds are subject to antifraud standards, though, and most are audited. But don't expect their managers to be any more forthcoming than necessary. "Managers don't reveal much about the specifics of their portfolio holdings and positions," says Joseph. "If they're planning to sell a company's stocks short—meaning they expect the price to drop—they generally don't want anyone to get wind of that."

Just how risky are hedge funds?

Hedge funds got a black eye in the 1990s, when some notorious portfolios—such as the Quantum Fund, formerly run by billionaire George Soros—had stupendous ups and downs. But some experts say the funds don't deserve the bad rap.

"Plenty of traditional mutual funds lost up to 70 percent in 2001, and aren't coming back," says Zucosky. "Tech funds and Internet funds were as risky as you could get." Adds Joseph, "Not all hedge funds are aggressive. Each fund follows its own investment mandate, focusing, for example, on mergers, convertible bond arbitrage, or small companies. Many hedge funds are tame in terms of volatility—as dull as watching corn grow."

But other advisers disagree. "Hedge funds can be risky," says Lee. "Some are run by managers who came from traditional mutual funds and aren't experienced with selling short. That strategy is very different; it involves a long learning curve, and it's not easy to execute. In addition, some hedge funds heavily rely on leverage, which can create large swings."

How can you tell if a hedge fund is risky or tame? You can't. Even financial advisers can find this task challenging. "Most advisers follow traditional mutual funds, but may not know more about hedge funds than you do," says Robert Levitt, a Boca Raton, FL, financial adviser who helps his clients invest in hedge funds. "Make sure you choose an adviser who has gone to conferences or seminars on hedge funds, has compared hedge funds, and the companies that start them, and has interviewed hedge fund managers," Levitt recommends. "Usually, an adviser who has been dealing with hedge funds and has relationships with the managers can also negotiate better fees and privileges for you."

Other downsides to keep in mind

Even if you're comfortable with the potential risk, you should still be aware of some other drawbacks of hedge funds. For one, their fees are much higher than those of traditional mutual funds. Typically, hedge funds charge 1 or 2 percent of assets plus 20 percent of profits. Often, though, the 20 percent doesn't kick in until after a certain threshold.

Hedge funds also bring a potential for a big tax bite. Because managers buy and sell so frequently, you incur high gains, usually taxed at your ordinary income tax rate. That's why hedge funds are most appropriate for retirement accounts, where tax consequences don't matter. Lack of liquidity is another drawback. Your money may be locked up for as long as five years, although typically it's a year. After that, you generally have to provide 45 days' notice of any withdrawals and may be limited to the number of those you can make in a year. Some funds allow you to take out money once a month; others limit you to four times a year.

Not everyone qualifies to invest in hedge funds, either. According to SEC guidelines, the majority of hedge fund investors have to be "accredited." That means your net worth must exceed $1 million; your individual income must have topped $200,000 for the past two years; or you and your spouse must have had joint income in excess of $300,000 for the past two years. Some funds may require you to invest at least $750,000 in other investment vehicles with the adviser before putting any money into a hedge fund, or that you have a net worth of over $1.5 million.

As we mentioned before, most hedge funds also require a minimum investment of $1 million. However, earlier this year, OppenheimerFunds launched the Oppenheimer Tremont Market Neutral Fund and the Oppenheimer Tremont Opportunity Fund, each of which requires a minimum investment of only $50,000. You (or you and your spouse) still do need to have a net worth of more than $1.5 million, though.

Both Oppenheimer offerings are "funds of funds," meaning they invest with a number of hedge fund managers, to diversify risk and decrease volatility. The Oppenheimer Market Neutral Fund is billed as a bond/fixed income alternative; the Oppenheimer Tremont Opportunity Fund includes equities and fixed income securities and is described as a balanced portfolio. Another investment company, Madison Funds, in New York, recently launched the Madison Microcap Opportunities Fund, which sets the minimum investment at $250,000. It will focus on arbitrage, meaning its managers will try to exploit the differences in price on investments that trade in multiple markets.

Finding the information you need

It's much tougher to get information on hedge funds than it is on mutual funds. But if you want to do some basic research yourself before seeking an adviser's help, two good places to start are the Web sites of HedgeWorld (www.hedgeworld.com), Van Hedge Fund Advisors International (www.vanhedge.com), and the Hedge Fund Association (www.thehfa.org).

"First, educate yourself about the different types of strategies," says HedgeWorld's Jeff Joseph. "If you can't or don't want to decide on one strategy, consider a fund of funds. That way, you get a variety of strategies." The price: You also pay an extra layer of fees, usually another 1 percent. HedgeWorld offers an online supermarket for hedge funds called FundSelect. You won't pay any fees, transaction charges, or commissions, says Joseph. However, you must be an approved member to access HedgeWorld FundSelect. Membership is free, as long as you're an accredited investor with some knowledge of alternative investments.

If you decide to invest in a hedge fund, a consulting firm can also help you analyze your options and pick the right fund for you. But its help won't come cheap. At Answers & Co., for instance, fees range from $2,500 to $25,000, says Daniel Strachman. "For $2,500, we help you understand hedge funds and what you should be looking for. For $25,000, we'll help you construct a hedge fund portfolio."

And recently HedgeWorld partnered with NCO Financial Investigative Services to produce independent, private investigative "due diligence" reports on hedge fund managers, checking for criminal record, pending lawsuits, judgments, tax liens, regulatory registrations and sanctions, and other important information. The fee is about $2,500 per report.

Decided to take the plunge? Then dive right in. "You should allocate 20 to 30 percent of the equity portion of your portfolio to them," says financial adviser Richard Lee. "The purpose of hedge funds is to diversify and manage risk, and if the funds are too small a percent of your holdings, they won't do you any good." So, if you don't have a strong stomach and at least $250,000 invested in stocks—$5 million if you're eyeing a fund with a $1 million investment minimum—better find another way to hedge your investment bets.

 

Leslie Kane. What's a hedge fund, anyway?. Medical Economics 2002;16:59.