Hedge Fund Investing: Why the “Edge” in Hedge Fund Has Two Sides

by Alexander Green, Chairman, Investment U
Friday, September 21, 2007: Issue # 713

I’m meeting with investment analysts in France this week, so I thought I’d dip into the mailbag for today’s column. One note from an Investment U reader asks how a hedge fund differs from a mutual fund.

It’s a basic question, but a good one. Especially with hedge funds – and their troubles – much in the news lately.

Hedge fund investing is like mutual fund investing in some respects. Investors pool their money to be managed by an investment professional. And their shares can be redeemed on demand.

But that’s where the similarities end…

Hedge Fund Investing: Endlessly Seeking Profits

Hedge funds go after high absolute returns. Mutual funds, on the other hand, seek high “relative returns.”

The difference is crucial.

For example:

• If the stock market drops 20% one year and your mutual fund falls only 10%, the fund company will often boast of their high “relative returns.”
• Hedge funds, on the other hand, are designed to seek profits in any type of market: up, down or sideways. To do this, they can invest in stocks, bonds, commodities, real estate, private partnerships, or (ahem) sub-prime mortgages, among other assets.
• Hedge fund managers can also bet on falling share prices. If a stock drops 50%, for instance, he can take a 50% profit. (Or more, if he’s using leverage.)

Hedge funds are generally free to invest in any market anywhere in the world. They can buy shares wherever the best returns are occurring. Maybe that’s in Japan. Or Britain. Or Australia. Or Hong Kong.

Hedge fund managers also like to take highly-concentrated positions. That means they don’t have to diversify into dozens or hundreds of investments, just to satisfy some requirement in their prospectus.

If a hedge fund manager sees only five great opportunities at a given time, he needn’t invest beyond those five.

Hedge Fund Diversification

Diversification can be a good thing, of course. But if a fund has dozens or hundreds of individual stocks, it’s very hard to post great numbers. (Especially after deducting management fees and other annual expenses.)

Overdiversification – combined with layers of fees – is why three out of four mutual funds cannot beat an unmanaged index like the S&P 500.

As Wall Street legend Gerald Loeb once said in his classic book “The Battle for Investment Survival“:

“Diversification is a necessity for the beginner. On the other hand, the really great fortunes were made by concentration.”

Hedge funds have yet another advantage as well. They are able to use “leverage” to magnify their returns. And this can make a tremendous difference when your investments are winners.

For all their advantages, however, hedge funds have their drawbacks, too.

Investing In Hedge Funds: Hard to Get In And Out

Let’s start with the fact that – unless you’re already rich – Uncle Sam won’t even let you in the door.

The Securities and Exchange Commission (SEC) prevents you from investing in hedge funds unless you can prove you’re an “accredited investor.” (That means you must have a net worth of more than $1.5 million, or income in excess of $200,000 in each of the last two years.)

If you meet these requirements, there are still other hoops to jump through…

Most hedge funds also have a six-figure investment minimum. (And for the good ones, it’s $1 million or more.)

Hedge funds don’t have daily liquidity, either. Most allow you to withdraw your money only once each quarter and some only once a year. Not good if you need cash in a pinch.

And, finally, there are fees. Lots of them. Most hedge funds charge shareholders 1% to 2% a year in management fees. Most hedge fund managers also take 20% of the net profits, in addition.

It’s called an “incentive bonus.” The idea is that you attract the most talented managers by coughing up 20% of your winnings in addition to the annual management fee.

What if the fund suffers a short-term loss? Rest assured, a hedge fund manager shares in none of that.

So to sum up, the advantages of hedge fund ownership are potential high absolute returns, possible low correlation with traditional stock and bond investments, and investment gains magnified by highly concentrated positions and/or leverage.

The disadvantages are high fees, lack of liquidity, potentially greater risk, and high investment minimums.

In short, if you’re going to invest in a hedge fund, expect to do a lot of due diligence both on the strategies and history of the fund, as well as the track record of the manager.

Good investing,

Alex

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