In a world of sluggish securities investment options, hedge funds may provide substantial returns. But beware the volatility factor and hefty management fees.
A senior telecommunications executive sold his company four years ago for seven figures. He socked away most of the proceeds into a traditional stock and bond portfolio but about a year ago, put some of his gains into an aggressive hedge fund specializing in the media industry, which chalked up a one-year gain of 35 percent. The chairman of an American Stock Exchange-listed company bought into a hedge fund specializing in financial company restructuring. One year later, the executive reports a net gain on the investment of 30 percent.
On the flip side, hedge-fund operator George Soros recently blew a cool $600 million in a currency deal that went sour. Investment manager David Askin ate humble pie when interest rates went the wrong way on his “market neutral” portfolio.
Hedge funds can bust or boom: The top 10 hedge funds in the International Advisory Group¹ data base returned an average 48.7 percent net compound annual return over a recent three-year period. But the proprietary data base distinguishes between 14 different classifications of funds (see chart), so prospective investors face a decision about which vehicle best meets their needs. And particularly with high-rolling fund managers requiring up to a 20 percent share of the profit – and a fixed 1 percent asset-management fee – due diligence is necessary to increase the chances of success.
WHAT ARE HEDGE FUNDS?
For the purposes of this article, we define hedge funds as U.S.-based private partnerships investing primarily in securities. Also, they usually provide the fund manager a portion of the profits.
The first hedge funds of the 1950s actually hedged by “selling short.” Today the definition has broadened, and some “hedge funds” never hedge. Today’s funds focus on maximizing pre-tax gains and should not be confused with the tax shelters of the ’80s, which focused on tax deductions. Nor should they be confused with public mutual funds, which are highly regulated.
While published estimates indicate there are up to 1,000 U.S. hedge funds, more likely there are about 3,000, with more being formed each month. Our data bank contains in excess of 1,500 funds using a broader definition, and about 900 using this article’s criteria. The number of hedge funds is growing rapidly, in part because money managers are attracted to the possibility of pocketing big fees. An operator with $100 million under management, who achieves a 30 percent annual increase for investors, stands to receive 20 percent of the increase or a cool $6 million for the year.
Many investment professionals form partnerships and bring in other investors. This way, they get a double bounce: the profits on their personal investments plus their cut of the profits. Typical hedge-fund operators have a significant portion of their net worth in their own vehicles and the savvy investor likes to see this.
The average minimum investment required to get into a fund is about $375,000 — too much for the smaller investor. And in any case, hedge funds generally accept only accredited investors with net worths in excess of $1 million. The hedge-fund operator has only 99 limited partnership slots to fill, so he or she needs to fill them with as many dollars as possible. However, regardless of the published minimums, the hedge-fund operator frequently will negotiate, particularly when promised additional investments later. Minimum investment time is often one year. For most funds, partial or total withdrawal subsequently can be made at three- or six-month intervals.
Individual funds vary widely in their objectives, strategies, minimum investment required, and minimum investment period.
The majority stress returns. At the other extreme, for the highly risk-averse investor, there is a whole group of funds that emphasizes low volatility. Many describe themselves as market neutral.
Some managers do an excellent job, keeping volatility down close to government-bond level but handily beating bond returns.
Another fast-growing category is the emerging market fund. Some of the newer ones are generating good results by carefully selecting countries and equities.
Funds of Funds, too, are much in vogue. Such a vehicle is a hedge fund that invests in other hedge funds. Some Fund of Funds operators, being in the business, are able to locate high-return hedge funds that the individual investor could not find alone. The aggregate returns of some are high enough that, even after their extra layer of fees, returns are still attractive.
Funds of Funds offer several advantages to investors. First, by combining the returns of different partnerships, the Fund of Funds operator lowers overall volatility and risk. Second, in a Fund of Funds, the investor often takes a stake in different portfolios with a single investment of a few hundred thousand dollars. For an individual investor to participate separately in, and meet the minimum investment requirements of, each of the individual funds, he or she normally would need at least several million dollars.
Because of the tremendous operating latitude available to many hedge-fund managers, their funds have inherent risks that do not exist tot he same extent in, say, mutual funds. Therefore, to lower risk, we recommend that investors who do not buy into a Fund of Funds create their own “synthetic” Fund of Funds by investing in at least 10 single diversified funds — if they feel they have adequate knowledge of portfolio construction.
The investor’s biggest challenge is finding a good hedge fund. Since almost any publicity for a specific hedge fund may be deemed illegal “advertising” by the Securities and Exchange Commission, this public relations can bring down on the operator a crowd of stern officials. Accordingly, many fund managers tend to be schizophrenic: While they want and need additional partners, they find themselves having to be publicity-shy. Accordingly, it is often financial insiders who tend to be in-the-know about good funds. These are generally executives of large financial-services companies who are part of the insiders network. They also may tend to be high-net-worth entrepreneurs who have made a point of cultivating financial insiders.
DIGGING FOR DOLLARS
In terms of individual funds, the media recently highlighted several stellar performers. Strome Partners, managed by Mark Strome, gained approximately 125 percent in 1993, while The Jaguar Fund, managed by Julian Robertson, increased over 66 percent. Strong performances for the 1994 first quarter include a 9.7 percent gain by EEGO, managed by Michael Jackson, and a 20.7 percent jump by Hawkeye, managed by T.G.Moran.
Once you have unearthed a potential nugget or two, your due diligence begins. Start with these questions: What are the annual net returns of the fund? How consistent are the returns, year by year? Are audited returns available? What kind of reputation does the principal have and what kind of objective references (investors, not friends!) can he or she provide? How much of his or her money is at risk in it? Are any investor complaints on file with state or federal authorities? Are you comfortable with the investing style — and with the investments? Has the fund performed well, not only in absolute terms, but also against appropriate benchmarks? For example, a hedge-fund manager who returned 40 percent annually in Mexican equities between 1988 and 1992 significantly underperformed the appropriate indices.
Once you’ve become comfortable with hedge funds, you usually should make up your mind to stick with individual investments for at least three years. Success cycles of several years can be seen for many managers. The investor’s classic mistake is to jump into a fund when it’s hot, only to have it turn ice-cold the next year. Those who ride it out usually will receive decent average returns over rolling three-to-five-year periods. Of course, not all leaky boats are destined to win a regatta: Homework on the cause of the decline should be done prior to a decision to stay on board. Has success made the manager terminally complacent (read lazy)? Has the world changed around a manager who hasn’t adjusted?
Seeking answers to these questions won’t always help you to pick a winner, and remember, past performance does not guarantee future success. But a lack of research may assure that you will pick a loser.