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How to Explain Hedge Funds

Everyone wants an edge, some extra advantage to help win the game. Like high-tech swimsuits that give competitive swimmers an edge or certain types of golf clubs that give players a longer drive, investors see hedge funds as that extra advantage. One day your client says, “Maybe I should own a hedge fund.” Here’s what you need to know.

What Your Clients Think

Television, movies and sensational news stories form the image of hedge funds in your client’s mind. Because Hollywood loves villains, hedge fund managers are usually cast in a bad light. They are portrayed as rich, evil and believing they are above the law.  Hollywood typecasts corporate executives the same way. In reality, many American companies are innovative and well-led. By recommending investing in stocks, advisors avoid Hollywood stereotypes about corporations. Do the same with hedge funds and reach your own conclusions.

The Facts

Hedge funds are complicated. Like mutual funds, hedge funds are an investment vehicle. Hedge funds are a container for investments. Mutual funds are very liquid.  Investors can get in or cash out daily. This requires the funds to invest in securities that can be turned into cash with the same speed. One of the many reasons for the stock market decline of 2008-2009 was that investors, alarmed by the market decline, chose to sell their equity mutual funds. This required the funds to liquidate stocks they held in order to satisfy redemptions, further fueling the decline.

Hedge funds, on the other hand, are illiquid. Investors can sell part of their position but only at set intervals such as quarterly redemptions. The primary reason for this is to allow the hedge fund managers to take the long view and buy assets that might not have a ready market if they need to be sold. Investors are trading liquidity for the potential of long-term gain.

Unlike mutual funds, hedge funds operate under a different set of rules. They can make extensive use of margin, using leverage while trading with borrowed money. They can use short-selling to profit from market declines. They can invest in options. Using movie analogies, the police cannot shoot a person dead in the street. James Bond can. He has a license to kill.

Investors often consider the entire category of hedge funds as one sort of magic investment. In reality, there are at least four categories of hedge funds, with further subcategories:

  • Global Macro – These hedge fund managers are looking at the big picture.  They predict something big is going to happen in the world, such as the economic troubles recently faced by Portugal, Italy, Greece and Spain. They can invest in multiple stock markets around the world. They might choose to focus on currencies. They might make major bets on oil. The adage “Buy on anticipation, sell on realization” describes the strategy.
  • Directional – Another set of hedge fund managers is betting on the direction of the stock market. Computer modeling plays a starring role. Managers might believe the market will rise and the advance will be led by the energy sector.  They focus their investments accordingly. If they predict a decline, they are shorting the market. This isn’t limited to the U.S. stock market. Some hedge fund managers might look to emerging markets where the average investor doesn’t have the knowledge to evaluate the situation properly.
  • Event-Driven – These hedge fund managers focus on specific companies. An acquisition might be rumored. Another company might be emerging from bankruptcy – bad news for the stockholders, but the bondholders might fare better. For example, when AMR Corp. filed for Chapter 11 bankruptcy in 2011, the company had $4 billion in cash. The bondholders and other creditors had a significant voice in the shape of the future company. Sometimes distressed securities don’t stay that way for long.
  • Relative Value – The stock market isn’t perfect. It’s rare for everything to trade at the right price simultaneously. Arbitrage is the strategy used for making money when the market misprices securities. A company might be involved in a takeover but the stock is trading at a discount to the buyout value, representing the risk the deal won’t go through. Enter the arbitrager. Lots of math is involved.  More computers too.
  • Other Strategies – Some managers might combine a couple of strategies versus specializing. Others might buy on margin in anticipation of a market rise while also shorting a sector because of an expected decline.

The Myths

Hedge funds have a mystical quality that attracts investors. But many of their assumptions are incorrect.

  • Myth: Only a few hedge funds are out there. Fact: There are approximately 10,000 hedge funds in operation, with approximately $2.7 trillion in assets.
  • Myth: Hedge funds are run by a few really smart people. Fact: Morningstar reports on 3,700 hedge fund managers. Bloomberg estimates there are 10,000 managers. These aren’t a few.
  • Myth: Hedge funds don’t fail. Fact: An estimated 117 hedge funds have failed since 2006.
  • Myth: Hedge funds are unregulated. Fact: At least six statutes or federal agencies require hedge funds to be registered and file reports.
  • Myth: Hedge funds consistently beat the market. Fact: Bloomberg reported in 2013 that the average hedge fund returned 7.1 percent (through November), which was about 22 points below the S&P 500. The Motley Fool notes the overall hedge fund average has underperformed the same index for five years.  Your hope is they will be noncorrelating when the market takes a major tumble.
  • Myth: Hedge funds earn a profit regardless of market conditions. Fact: They try and intend to achieve this aim. Risk-based return is the new buzzword.
  • Myth: Hedge funds trade on inside information. Fact: The majority of hedge fund managers are law-abiding. They are overseen by multiple regulatory agencies. On a more practical level, how can every one of 10,000 hedge fund managers each know something the others don’t?
  • Myth: Hedge funds are for only the super-rich. Fact: Suitability plays a major role. Investors in hedge funds and other alternative investments must meet certain minimum asset standards to establish that liquidity isn’t a problem (they don’t need to touch the money soon) or they can afford to lose the money.  They are risky investments. However, once the public gets interested, major firms find a way to bring hedge funds to them.

The Advantages

Despite the myths, there are compelling reasons alternative investments, hedge funds in particular, should be part of a sophisticated investor’s portfolio.

  • Noncorrelating assets (1) – Hedge funds can bet against the direction of the market. Peter Lynch, the famous mutual fund manager of Fidelity’s Magellan Fund, has long been a great believer in remaining fully invested, because you don’t know when a declining market will turn around. Using this strategy, long market equity investors ride the market down. Owning an asset that should move in the other direction provides an offsetting advantage.
  • Noncorrelating assets (2) – The Credit/Suisse Tremont Hedge Fund Index reported a decline of 19 percent for 2008. Meanwhile, the S&P 500 declined by about 37 percent. The top performing hedge fund in 2008 returned a positive 37 percent.
  • Illiquidity has advantages – The ability to get out on short notice requires mutual funds to avoid certain investments. The ability of hedge funds and private equity investments (that’s another story) allows them to focus on realization of a strategy over the long term.
  • There really are smart people – The hedge fund index might have lagged the stock market in 2013, but you aren’t buying the index. You are buying into a certain fund. According to zerohedge.com, measuring into October 2013, several funds posted returns in the 40 to 50 percent range or above. As with mutual funds, you need to find the right ones.
  • Diversification is prudent – You diversify across stocks, bonds and cash. You invest internationally. Why stop there?

The Drawbacks
Hedge funds have that mystical quality.  Here are some other factors to consider:

  • Fees – They are famous for “pay for performance” pricing. The industry standard is a 2 percent fee on assets plus 20 percent of the profits. If the hedge fund is imbedded in a packaged product, expect additional fees.
  • Liquidity – Invest money you won’t need for a long time. You’ve heard the saying “Don’t wait to buy real estate. Buy real estate and wait.” Use the same logic.
  • You need diversification – You wouldn’t buy one stock or one mutual fund.  Why? Because they represent a single industry or style of investing. If possible, spread the risk by buying multiple styles.
  • You must be alert – If you buy through your advisor, it’s likely your hedge fund position is listed on your statement with an estimated value. Is it performing as advertised? If not, ask questions. 
  • Tax reporting – Hedge funds often issue separate, specialized tax reports.  These need to get to your client’s accountant before a tax return is filed.

They Really Want One – How Can They Buy One?

If your client wants a hedge fund and it’s a suitable investment, ideally you want to provide it through your firm.  Look for the following:

  • Individual hedge funds – Does your firm offer the ability to invest with one specific manager through a product that has lower minimums than the product bought by an institution? How have those managers performed?
  • Fund of funds – Perhaps your firm has established a position with 50 to 100 hedge funds and packaged a product for sale to retail investors. Now you have diversification. However, you stand a good chance of getting an average return with that many participants.
  • Mutual funds – “Hedgelike” mutual funds exist. Does your firm provide access to them?  Are the funds any good?
  • Hedge fund within a variable annuity – Annuities are often considered long-term investments. Some variable annuities offer hedge fund participation as an investment choice. Do you have a similar offering?

Hedge funds have a mystical quality for investors. They have a place in the experienced investor’s portfolio, but you and your clients approach them with eyes wide open.

is president of Perceptive Business Solutions in New Hope, PA. His book "Captivating the Wealthy Investor" is available on Amazon.com. He can be reached at [email protected].


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