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MAKING CENTS OUT OF THE NEWS
Blog #34
(September 3rd, 2009)
HEDGE FUNDS – JUST A LITTLE TOO EDGY FOR COMFORT
By Tom McAllister, CFP®
In investment terminology, to “hedge” means to manage risk. In theory, hedge funds, which were extremely popular prior to last fall’s market meltdown, work by balancing speculative investment positions with investments designed to react in exactly the opposite manner. Hedge fund managers can use a variety of financial tools, including holding cash positions, short selling, options, swaps, futures, commodities, and currencies.
Given the recovery we've experienced in the market in recent months, individual investors might be tempted to move money into hedge funds. I've decided to devote this blog post to the subject of hedge funds to discourage readers and clients from such a move.
By way of explanation for my position on the subject, let me first clarify the fact that, while many refer to hedge funds as a single category of investment, there are many different types. Some hedge fund portfolios include mostly stock positions, with different option strategies for trading those stocks. Commodities futures funds use high leverage to speculate in the arena of commodities. There are merger arbitrage funds, bankruptcy situation funds, and multi-strategy funds which blend different types. Many, if not most, hedge funds use borrowed money (leverage) to enhance yields (risk is enhanced as well!).
While the risk levels of hedge fund differ, there is one primary reason for the fact that, in more than 47 years as an investment advisor, I have yet to recommend any hedge funds to my clients, and that reason is hedge funds' fee structure.
Typical hedge fund fees are 2% annually plus 20-25% of any profits. If the fund loses money in a given year, the losses are carried forward and must be made up in subsequent years before the manager again shares in the profits. This feature creates a very strong incentive for a manager to simply close down the fund, distribute any remaining principal, and organize a brand new fund!
It is imperative for individual investors to understand the additional risk imposed by this type of fee structure. As an example, assume the manager of Happy Hedge Fund excels, growing by 14% annualized, net of trading costs, which is 5% better than the stock market's historical 9% return. On the surface, Happy Hedge Fund appears to have delivered an outstanding result. But, after subtracting the 2% management fee, the return is 12%. Then, if the manager keeps 20% of that, the return is almost exactly what the stock market has returned to investors since 1920!
In a financially disastrous year, by contrast, losses in a hedge fund can exceed 50% in a leveraged fund. The manager is virtually certain to shut down the fund rather than face 7-10 years with no profit-sharing. An investor would have been far better off with a no-load index fund with far, far lower risk.
My hope is that understanding the risk levels that are inherent in hedge fund structure will explain to my readers why there is almost NO reliable historical data available from hedge fund managers. Whatever self-reported performance statistics that can be found are severely biased. Funds that have done poorly are out of business and are not included in the reporting! Any index of a particular type of hedge fund, then, would simply include only those that have survived.
Hedge funds, I believe, are too volatile and too risky for most investors.
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