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Hedge
Funds
(if you aren't George Soros)
by Caroline Maxwell, 2006
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 have been steadily
growing in popularity over the last few years, 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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