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Hedge
Funds
(if you aren't George Soros)
by
Caroline Maxwell, 2008
IMPORTANT
WARNING: The contents of this article have been
compiled in good faith by Investorsoffshore.com
to provide assistance to investors, but do not
constitute investment advice or recommendations.
Investors should not rely upon the information
given in order to choose types or routes of investment
but should make their own independent enquiries
before making choices. Investorsoffshore.com has
taken reasonable care in researching and presenting
the information herein but makes no representations
as to its accuracy and accepts no liability for
actions taken or not taken as a result.
From
the amount of speculation and debate that has
surrounded hedge fund investment in recent times,
you could be forgiven for thinking that hedge
funds were a relatively new development in the
investment world. However, you would be wrong.
The
first fund to be dubbed a 'hedge' fund was the
A.W. Jones Group in 1949. The fund derived its
nickname from its strategy of taking long and
short positions in the stock of companies (a strategy
which continues to be central to many hedge fund
managers, and which will be explained in greater
detail in the next section). This meant that it
could hedge against macro-economic factors, while
at the same time benefiting from the individual
performance of specific companies.
Hedge
funds offer the potential for attractive returns,
and are a lot more nimble than traditional mutual
funds or other investment structures, which makes
them an especially suitable option in volatile
or falling markets (sound familiar, anyone?) They
require high minimum investments, and until recently,
were only allowed to accept 'accredited', or 'qualified'
investors (about which more later).
Their
special position with regard to the regulatory
authorities in most countries means that marketing
of hedge funds to the general public has been
severely restricted.
However,
despite these obstacles, hedge funds grew steadily
growing in popularity until 2008, when the credit
crunch caused a period of shrinking asset values,
raising a number of issues for regulators, financial
service providers, and investors alike. In this
Investors Offshore special feature, we take a
close look at hedge fund investment, examining
both the advantages and disadvantages for individual
investors. We take a look at the opportunities
available, how and where you should invest, and
the due diligence issues which must be considered
before taking the plunge.
Advantages
Of Hedge Funds
As previously mentioned, hedge funds are a lot
more nimble than their mutual fund counterparts.
This is because they are governed under a different
(and much more permissive) regulatory system than
traditional funds, which means that they are permitted
to use instruments and strategies beyond the reach
of conventional mutual funds, in order to secure
the highest possible profit for investors and
best manage investment risks.
Broadly
speaking, hedge fund managers, unlike mutual fund
managers, are able to change the style or strategy
used by the fund without prior investor consent,
and the spectrum of styles available is enormous.
The following (by no means exhaustive) list outlines
some of the main strategies utilised by hedge
fund managers, and the way in which each hopes
to affect the performance of the fund:
-
Event driven. This strategy involves
taking different positions in companies which
are involved in takeovers, mergers, or acquisitions,
or are in distress, in the hopes of predicting
the effect that the event will have on their
share prices.
- Global
International. Investing either in established
markets, or in more risky emerging economies.
- Global
Macro.
Seeks to benefit from global macro-economic
changes and developments.
- Long.
Taking a long position in a stock is what most
traditional investors and mutual fund managers
do - they predict that the value of the stock
will rise. However, in a hedge fund, alternative
financial instruments can be used.
- Market
Neutral. This involves taking both long
and short positions in the same market or sector
in order to offset risk - basically like betting
on two sides of the same coin.
- Sector.
Investing in a specific sector, for example
financial services, real estate, or technology
and communications.
- Short.
This strategy involves finding overvalued companies,
and selling borrowed stock in them in the hopes
of buying it back later at a lower price.
There
are many more strategies open to hedge fund managers,
of course, and they are able to chop and change
as market conditions dictate.
Hedge
fund managers are usually highly skilled and experienced,
as the system and rates of compensation for successful
managers tend to be very attractive. Although
a successful mutual fund manager may well be able
to afford a weekend home with a pool on his earnings,
a successful hedge fund manager is more likely
to have a weekend home with an island. Or so the
saying goes.
General
partners are compensated in a very different way
to mutual fund managers, as the majority of their
fee is based on how well the fund performs. Generally,
their fee is something like 1-2% of the total
assets of the fund, plus a performance or incentive
based fee. Some funds also stipulate a 'watermark'
or 'hurdle' which the fund must outperform in
order for the manager to profit. Hedge fund managers
are also usually more heavily invested in the
funds they run themselves, and so have more of
a vested interest in ensuring that the fund performs
exceptionally. Mutual fund managers usually base
their fees on the volume of assets managed, regardless
of performance.
Disadvantages
Of Hedge Funds
Which brings us neatly onto the possible disadvantages
of hedge fund investment. Although the way in
which hedge fund managers are compensated can,
and in the majority of cases does, encourage excellence
and shrewdness, it can also sometimes encourage
greater risk-taking in order to ensure that the
fund is productive.
The
relative lack of regulation in the hedge fund
sector of most countries is something of a double-edged
sword, and the ability to invest in 'volatile'
sectors or instruments can sometimes present a
risk. The occasional demise of very large hedge
funds, such as Long Term Capital Management has
enhanced the public perception of this risk.
The
SEC attempted to tighten registration rules for
hedge funds in 2005 by changing
the definition of a "client" under the Investment
Act of 1940 so that hedge funds managing more
than $30 million in assets with more than 15 clients
would be obliged to register as investment advisers.
Between
700 and 800 hedge funds were expected to register
with the SEC, including more than 100 hedge funds
based outside United States, by the time that
the new rules were expected to come into force
in early 2006.
After
a series of legal see-saws, however, Christopher
Cox, chairman of the United States Securities
and Exchange Commission, announced in August,
2006, that the SEC would not seek to appeal a
court decision which overturned the regulator's
registration rule.
In
June 2006, a three-judge panel of the US Court
of Appeals for the District of Columbia Circuit
unanimously struck down the SEC's hedge fund adviser
registration rules under the Investment Advisers
Act, in the case Phillip Goldstein, et al.
v. Securities and Exchange Commission.
Based
on advice from the SEC's Solicitor and General
Counsel, Cox said in a statement that it would
be "futile" for the Commission to appeal against
the decision since the ruling was based on multiple
grounds and was unanimous.
Many
experts feel that the risky nature of hedge fund
investment has been overstated. Although managers
are generally somewhat secretive about investment
strategies, and reporting to investors does not
take place as frequently as with conventional
investment vehicles, there is no fundamental and
necessary reason why hedge funds should present
more of a danger. On the contrary, academic research
conducted over the past few years has shown that
hedge funds have had higher historical returns
than traditional stock and bond investments of
similar risk.
In
reality, less than 5% of the world's hedge funds
utilise 'risky' investment strategies such as
global macro or emerging markets. Most hedge funds
only use derivatives for offsetting market risk,
and many do not use leverage at all. (Leverage
is the extent to which an investor, business,
or fund is using borrowed money to finance transactions).
Be
that as it may, securities regulators have always
been keen that inexperienced domestic investors
are not exposed to any more risk than is strictly
necessary, and one area in which they do impose
strict regulation for hedge funds is in the barriers
they place in the way of investors themselves.
As
well as passing muster in terms of investment
knowledge and experience, a potential investor
must be prepared to stump up a sizeable minimum
investment, and must be able to demonstrate a
substantial net worth. This is in part to deter
the unwary, and in part because as hedge funds
are limited by the authorities in the number of
investors that they can accept, a large sum is
needed from each investor in order to make the
venture worthwhile.
The
criteria for accredited, or qualified investors
have traditionally been defined as follows in
America, and it is safe to assume that similarly
stringent definitions exist in other countries,
although consultation with an independent financial
advisor will clarify exactly what the situation
is in your country of residence:
-
Must have an individual net worth, or joint
net worth with spouse exceeding $1 million,
or;
-
Must have had an individual income of $200,000
(or joint income of $300,000) in the two years
preceding, and have a reasonable expectation
of a similar level of income in the current
year, or;
-
Must be an institution, employee benefit plan,
partnership, or foundation which meets the accredited
investor criteria.
At
this point you may be wondering why, if all but
the super-rich are excluded from investing in
hedge funds, we have bothered to write a primer
on hedge fund investing. Well, as the 'mass affluent'
group continues to grow, so does the popularity
of hedge funds, a trend which has meant that service
providers are beginning to see the possibilities
inherent in the sector, and are looking at ways
in which to offer the increased profitability
found in hedge funds to the individual investor.
In the next section, we will be looking at the
investment opportunities open to those unfortunately
excluded from the Forbes list, but not quite in
the poorhouse!
Hedge
Funds - Where From?
Although
the times they are a'changin (sorry
) for
hedge funds, the days of online deep discount
hedge fund brokers and hedge fund supermarkets
are still some way off. Despite, or perhaps because
of, growing investor curiosity, regulators are
still cautious, and will allow hedge fund providers
and managers opportunities to attract more mainstream
investors only as they prove their trustworthiness.
There
are a growing number of hedge fund portals and
one-stop sites for investors, advisors, and the
industry alike, and they tend to offer a variety
of services, including the provision of news,
performance data, topical articles, and sometimes
databases of contact information for service providers.
As a result of still stringent regulation in the
majority of countries, in order to access sensitive
information (such as contact details or performance
data) it is usually necessary to register.
For
the moment at least, there are basically three
ways to access hedge fund investment opportunities:
-
Invest directly.
This is only really an option for accredited
investors (using the definition described above)
and institutional investors due to fairly prohibitive
investment criteria.
- Invest
through an investment management company, wealth
manager, or independent financial advisor.
Probably a more suitable option for the mass
affluent investor, as an outside financial consultant
is more likely to be 'in the loop'. (Because
of the restrictions on advertising, a great
deal of hedge fund information is circulated
by word of mouth, or on designated news sites,
so contacts are important. Investing in this
way also offers an added advantage (well not
really an advantage, more of a necessity actually);
an advisor will be able to take you through
the appropriate options for your country of
residence, personal circumstances, and net worth.
- Invest
through a third party firm.
As interest in hedge funds grows, a number of
financial service providers are offering opportunities
to invest in what are essentially funds of hedge
funds, thus spreading both the perceived risk
and the cost of minimum investment.
Funds of Hedge Funds - How To
Funds
of hedge funds, as the name suggests, offer diversification
across a range of hedge funds at lower minimum
investments. They are able to do this because
they pool the resources of multiple investors
- it has been estimated that to gain proper diversification,
an individual investor would need to invest in
at least 5-6 hedge funds, a feat which all but
the very richest individual would find it difficult
to achieve. Funds of funds can do just this because
of their greater purchasing power. Typically,
funds of funds will include a variety of asset
classes such as equities, bonds, cash, alternative
strategies, and real estate, but obviously the
make-up varies considerably from product to product,
and increasingly there are funds of hedge funds
(FoHF).
Another,
not inconsiderable advantage to investing in hedge
funds in this way is that investors are able to
take advantage of the expertise and resources
of a number of industry professionals, as FoHF
investment by necessity takes a multi-manager
approach. FoHF investing may also provide access
to hedge funds which would otherwise be closed
to new money due to regulatory and capital restrictions.
Critics
of this type of investing point to the likelihood
of a higher fee structure in order to absorb both
the management costs of the underlying hedge funds
and of the FoHF itself, as a significant disadvantage.
However, the costs involved although higher than
with ordinary mutual fund investment, are unlikely
to be doubled, as many fund of hedge funds providers
have agreements with the hedge funds to reduce
the amount of fees paid, a saving which is then
passed on to the investor.
However,
even if you do decide that this is the way forward
for you, it is always strongly advisable to consult
with a qualified financial professional before
proceeding. Not only will they be able to help
you choose the fund that is right for you, but
they may well have access to information regarding
performance and cost which is simply unavailable
to lone individual investors.
Hedge
Funds - Due Diligence
Although due diligence is a must prior to each
and every investment decision, for hedge funds
it is doubly so, for all the reasons previously
mentioned. If you choose to invest in a fund of
funds, a lot, although not all, of the work will
have been done for you, but there are still some
basic issues to be addressed before you part with
your hard-earned (or inherited!) cash. The following
is not a comprehensive list, however, so here
again, professional advice is necessary.
The
Fund (Or Funds
)
-
Volatility - look at the fund's volatility
over monthly (or weekly) periods if these figures
are available. Also look at whether the annual
return was generated evenly throughout the year,
or whether it is the result of one or two large
gains in specific periods.
- Breadth
- if possible, check whether the general partner
turned an even result on all issues, or whether
one lucky trade accounted for good results.
- Repetition
- is the investment process repeatable, or were
good returns the result of dumb luck?
- Strategy-specific
risk - important if you are investing directly
in just one hedge fund, but slightly less so
if you choose to invest in a fund of hedge funds
due to the greater diversification offered.
Still, you should make sure you understand the
particular risks inherent in each hedge fund
manager's strategy.
- Leverage
- look at to what extent the fund uses leverage
to make transactions, the fund's rationale for
this device, and whether leverage has ever been
revoked for any reason. Obviously, the extent
to which a hedge fund uses borrowed money, and
the rationale behind it, will affect the riskiness
of the investment, so this is an important one.
The Key Personnel
-
Background - look into the general background
of the hedge fund, including the division of
responsibility, its formation and structure,
fund terms and relationships, and possible conflicts
of interest.
-
Manager profile - look into the background,
qualifications, employment history and track
record of the manager or managers.
-
Reporting - Ascertain who the custodian
of the fund's assets is, and also who the prime
broker is. (And beware of any fund or hedge
fund which asks you to send funds directly to
it - they should always go to the prime broker
or custodial bank.)
-
Administration. Find out whether the
hedge fund manager uses a third party administrator
to calculate monthly returns, and ask for background
on the fund, their calculation methods, where
their data comes from, and what procedures they
have in place for ensuring that the terms of
the fund are being upheld. However, concentration
on the terms of the fund is more crucial with
mutual fund investing than hedge fund investing
given the fact that hedge fund managers can
change strategies at a moment's notice to fit
market conditions
-
Other investors. Although to a certain
extent, you will already be aware of the general
profile of other hedge fund investors (i.e.
middling to filthy rich!), ask for any information
that is available on the breakdown of institutional
vs. individual investors, average investment
amounts, etc. It may give you a clearer idea
of whether the particular fund, or fund of funds,
is suitable for you.
Hedge Funds - A Worthwhile Investment?
Hedge
fund investment, although it appears to be slowly
becoming more accessible, is never going to be
the poor man's choice, and regulatory nervousness
on the part of many authorities will mean that
there is unlikely to be a headlong rush for the
bandwagon. However, this is, in many ways, a good
thing, as long experience (south sea bubbles,
Dutch tulips, technology stocks, etc), has shown
that a sudden rush of interest from the general
public can often be too much of a good thing.
Also, the vast majority of hedge funds, by their
very nature, would lose a great deal of their
nimbleness if they became over-subscribed.
However, the increasingly diverse opportunities
within the sector, and the ever growing body of
knowledge surrounding the subject mean that for
a relatively wealthy and experienced investor
in the right circumstances, hedge fund investment,
or more realistically, investment in a fund of
hedge funds, could be a financially exciting alternative.
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