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Understanding Hedge Funds
Understanding Hedge Funds
by Charles B. Schaap 11/2006
For some investors, hedge funds might seem like
unregulated, high risk ventures where you can lose all your
money. Others might see them as actively managed funds,
which provide high returns regardless of market conditions.
But most would probably agree that hedge funds are not well
understood by the investing public.
Hedge funds are private investment pools, so the lack of
public awareness is largely because hedge funds are
restricted by law from advertising. Most investors hear
about hedge funds through word of mouth, investment
advisors, or stock brokers. If an investor is interested in
learning about a particular hedge fund opportunity, they
must actively request information from the fund. With a
lack of public presence, many hedge fund myths and
misconceptions have persisted, especially in the media.
Hedge funds are an alternative investment vehicle for high
net worth individuals and institutions. Hedge funds are
much different than the traditional mutual fund. To "hedge"
means to avoid or lessen investment risk by offsetting one
investment by another investment. The most basic type of
hedging is to hold both long (betting price will rise) and
short (betting price will fall) positions at the same time
in order to reduce risk. This type of strategy was first
developed by sociologist Alfred W. Jones in 1949.
A good way to understand this concept is to remember what
happened after the market bubble burst in 2000. If an
investor had maintained 100% long positions during the
market decline from 2000-2003, they would have suffered big
losses. Suppose instead that an investor had held a mixture
of long and short positions during the decline and let's
assume further that all asset prices in this portfolio
fell, during this period. The losses from the long
positions would be offset against the profits from the
short positions, thereby reducing market risk and limiting
losses. While this is a simplistic, theoretical model, it
does illustrate the basis on which many hedge funds control
losses with long/short hedging strategies.
Today, "hedge fund" applies less to the hedging process and
more to how hedge funds are structured and managed for the
various types of strategies they use. Hedge funds are a
private investment pool formed under a limited partnership
agreement. The investors are "limited" partners; they do
not participate in the fund's operations, and their
liability is limited to the amount of capital invested. The
fund manager is the "general" partner, who is responsible
for operating the fund and is liable for any potential
misconduct under Federal Securities Laws.
Unlike mutual funds, not everyone is eligible to invest in
a hedge fund. For an individual to be an "accredited
investor," they must have a minimum of one million dollars
of liquid net worth. Institutions (pensions funds,
endowments, investment banks.) can also invest in hedge
funds as "qualified purchasers" if they have at least five
million dollars in assets. Hedge funds have a minimum
investment amount which is usually $250,000.
Hedge funds are loosely regulated by the Securities and
Exchange Commission. In contrast, mutual funds are highly
regulated; but regulation comes at a price. Mutual funds
are largely prohibited from using leverage and shorting.
During the 2000-2003 market decline, they either held long
positions or partially went to cash. In contrast, hedge
funds were able to short during the market decline. Hedge
funds are allowed a wide range of investment options, such
as shorting, leverage, arbitrage, and derivatives, which
allow them to take advantage of all market conditions and
produce higher returns.
Hedge funds also have an incentive to outperform
traditional investments. As part of their compensation,
hedge funds charge a performance fee, commonly 20% of
profits. In addition, fund managers usually invest their
own money in their hedge fund. Hedge funds seek absolute
returns and pursue profits under all market conditions,
including bear markets. In contrast, mutual fund
performance is compared to the general stock market and is
highly dependent on a bull market to create positive
returns. The mutual fund manager's compensation is based on
assets under management rather than their performance.
One of the biggest misconceptions about hedge funds is that
they must take excessive risks in order to gain higher
returns. The best hedge funds are specialists at minimizing
risk and make it an integral part of their investment plan.
Conscientious risk management serves to limit losses and
promotes more consistent, generally higher risk-adjusted
returns. Hedge funds are also more actively managed than
mutual funds and use more advanced strategies such as
shorting and leverage which require greater skill. Active
management also places greater emphasis on making the right
investment at the right time. It's no wonder hedge funds
attract some of the brightest minds on Wall Street.
Most hedge funds are highly specialized in the type of
investment strategy they use. There are over a dozen
different types of hedge fund strategies, and each fund is
based on a particular strategy and the financial
instrument(s) traded (stocks, options, or futures, etc).
For instance, one type of stock fund seeks to provide high
returns by investing in growth stocks (Aggressive Growth
Fund) while another looks to generate consistent income
with dividend-paying stocks (Income Fund). There are also
"funds of hedge funds" which are funds that invest a
portion of their capital in each of several different hedge
funds. It is important for an investor to understand the
type of hedge fund which best fits their portfolio because
funds vary in risk and return.
Investors should also research the fund manager's
background and experience as well as the hedge fund's track
record, although past performance does not imply equivalent
performance in the future. Many hedge funds now list their
returns at websites. Hedge funds will provide accredited
investors with documents that cover key information about
the fund including the structure, rules, and investment
objectives. One can also use a research consultant, who
specializes in hedge fund analysis. For general information
about hedge funds, a good place to start is the
not-for-profit Hedge Fund Association (www.thehfa.com).
Hedge funds are not for everyone, and they are not intended
to replace traditional investments. Hedge funds can serve
an important and valuable role in a well-diversified
portfolio, especially since hedge funds reduce market risk
by achieving positive returns during market declines. The
more an investor understands hedge funds and their
operation, the more they can set aside myths and
misconceptions and capitalize on the advantages that hedge
funds can offer.
For further information contact Dr. Charles B. Schaap.
TraderDoc@TraderDoc.com 702-361-5161
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