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Hedge Fund Investing: Why the “Edge” in Hedge Fund Has Two Sides
by Alexander Green, Chairman, Investment U; Investment Director,The Oxford Club
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.
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 funds, on the other hand, are designed to seek profits in any type of market: up, down or sideways.
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.
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.
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
Alexander Green is the Investment Director of The Oxford Club. A Wall Street veteran, he has over 20 years experience as a research analyst, investment advisor, financial writer and portfolio manager.
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