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!

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.