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Why Invest in a Hedge Fund?

Rewards and Risks for Individuals

Hedge funds have earned a grandiose reputation, thanks to the spectacular success of some funds and the tumescent wealth of some fund managers, and the equally spectacular failures of some other (and even some of the same) hedge funds and the humiliations that followed. Some high-profile hedge funds grew so large in the 1990s that they could disrupt markets and economies; one catastrophic failure, that of Long-Term Capital Management (LTCM) in 1997-98, nearly caused a global crisis. The opacity and relative freedom from regulation, and “black box” investment strategies, only add to the mystique of the industry.

What’s in it for individual investors? No doubt about it, many investors have done well by diversifying into hedge funds. Even those who have done poorly nevertheless earned the right to effluviate over their hedge fund positions down at the country club and in the skybox at halftime. For some adventurers, losing money in a hedge fund is not as shameful as never investing in one at all. Excitement and status can be powerful incentives even for accredited investors, although we hope that your incentive is old-fashioned ROI.

Back Down to Earth

In this article, and the series of articles that follow, we will try to bring the hedge fund investment class down to earth and into sharper focus, with return on portfolio investment as our guide instead of excitement or status. Our introductory article answered the question, “What is a Hedge Fund?” as realistically and concisely as possible.
Your next question surely will be, “Should I invest in a hedge fund, or maybe a fund of hedge funds?” To help you decide whether to consider investing in this asset class, we will cover the following topics in this article:

A. Who has historically invested in hedge funds?
B. The potential rewards for individual investors
C. The risks for individuals
D. Should individuals invest in hedge funds in 2013?
E. If so, what’s the next step?

A. Who invests in hedge funds?

In the early days of hedge funds — the 1950s through the 1980s — outside investors (other than the fund managers themselves, who typically invested a significant portion of their own wealth in their funds) were mostly wealthy individuals and family offices. Since then, institutional investors (predominantly public and private pension funds, but also insurance companies, charitable foundations, university endowments, etc.) have gradually diversified into hedge funds. By 2007, institutions owned slightly more hedge fund assets than individuals, according to some researchers. (e.g., Greenwich Associates).

Caveat: because of the opacity of hedge funds and relative lack of reporting, statistical data and industry performance results may vary, and different research firms often produce conflicting figures.

Since the global financial crisis of 2008-2009, new capital coming into the industry has been predominantly from institutions, according to KMPG and the Alternative Investment Management Association. By 2012, institutional investors represented 61% of the $2.13 trillion invested in hedge funds worldwide, aside from managing partners, according to research by Preqin and confirmed by Deutsche Bank. Funds of hedge funds represent about 22% of assets, according to AEI. (Compare that with $11.6 trillion in the U.S. mutual fund industry in 2011, according to Investment Company Institute.)

Conflicting data: According to KMPG in 2012, outside of fund partners, 40% of investment came from institutions, 17% from funds of hedge funds, and 43% individuals and family offices.

B. Hedge Fund Benefits and Rewards

Given the recent ebb of individuals from the hedge fund asset class, and the fact that 2012 was a bad year for the industry (with average returns of about 5.9 percent compared with 12.6 percent for the S&P 500, year-to-date through November 21, according to Goldman Sachs), well, do you have to be crazy to consider investing in a hedge fund in 2013?

Let’s consider the benefits and rewards first, then the costs and risks. Here are the four primary reasons to invest in a hedge fund, aside from bragging rights:

1. Absolute return. Conservative hedge funds, which invest in alternative assets (uncorrelated with the equities and bond markets) and/or take offsetting short and long equity positions, aim to make money from falling as well as rising markets. By and large, hedge funds do succeed at this, according to the Hedge Fund Research index, which shows that from 1990 to 2010, there have been only two negative years for the average hedge fund. (Source: Philip Coggan, Guide to Hedge Funds, Wiley, 2011, pg. 8)

2. Shelter from volatility. Most hedge funds aim to provide diversification for portfolios dominated by traditional investments, moderating risk and volatility. (Not all hedge funds aim to reduce volatility, however; some, like those that place large, highly leveraged directional bets, aim aggressively for monster returns.) According to the Hennessee Group, hedge funds were approximately one-third less volatile than the S&P 500 between 1993 and 2010. (Source: “Hennessee: Protecting Capital During Market Downturns,” Hedge Fund Journal, 22 July 2010)

3. Superior management talent. High management fees (typically 2% of assets under management and 20% of gains each year) and relatively unfettered investment styles attract experienced, successful investment talent from large banking and money management firms to the hedge fund industry. Unfortunately, past success is no guarantee of future performance, as the geniuses at LTCM proved.

4. Dramatic overall returns. Yes, there are investors who just want to make a killing and believe that certain kinds of hedge funds offer the best risk/return profile for that purpose. Those that use leverage are able to magnify returns (as well as losses). In any given year, a few funds produce high double-digit returns (and some in the low triple digits); some build impressive, long-term double-digit records — such as Paulson Credit Opportunities, which cleaned up by betting against subprime mortgage-backed securities during the financial crisis.

Long-term successes like Paulson are rare, however. According to an article in the Journal of Financial Economics, from 1980 through 2008 the average hedge fund returned an annualized 6.1% after fees, compared with 10.8% for the S&P 500. (Source: Bob Frick, “Are Hedge Funds Right for You?” Kiplinger’s Personal Finance, October 2011.)

Be careful whose statistics you rely on. Despite media hype around the most successful funds, “the body of historical evidence demonstrates that once viewed on a risk-adjusted basis, the average hedge fund has a hard time keeping pace with Treasury bill returns,” say Larry E. Swedroe and Jared Kizer in *The Only Guide to Alternative Investments You’ll Ever Need* (Bloomberg, 2008, pg. 210).

According to a Morgan Stanley presentation in 2010, the reason cited overwhelmingly for investing in hedge funds was to diversify portfolios so as to decrease their volatility (56% of survey respondents).

C. Hedge Fund Costs and Risks

Funds that primarily make big directional bets, rather than aiming to reduce volatility, pose the greatest risk to investors. Other costs and risks include:

1. High barrier to entry. Each fund sets a minimum investment amount, although the fund manager may waive the minimum at his or her discretion. Smaller funds typically require around $250,000 to enter, midsize funds often have $1 million minimums, while larger funds may start around $5 million to $10 million. (Funds of hedge funds usually have lower investment thresholds.) Of course, this high barrier makes hedge fund investors members of an extraordinarily elite club, and who’s to say that in itself is not worth the price of admission?

2. Loss magnified by leverage. Unless highly leveraged bets are effectively hedged, they can result in catastrophic losses (or spectacular gains). According to a 2011 report by the National Bureau of Economic Research, the average leverage for hedge funds is between 1.5 to 2.5, which is actually low compared with the average leverage for investment banks of 14.2.

3. Short risk. Taking short positions in equities may help to hedge a portfolio, but it also creates unlimited downside (because prices can rise without limit). It also incurs borrowing costs.

4. Illiquidity. In some funds, the initial investment may not be redeemed (the capital is “locked up”) for a specific period, such as a year. After that, investors’ ability to redeem their capital is generally restricted to a narrow window each quarter (or each year). In certain critical circumstances, investors’ capital may be frozen for longer periods (by restrictions known as “gates”) to give fund managers more strategic flexibility. In addition to the illiquidity of the fund itself, fund managers may invest in illiquid securities.

5. Non-disclosure and fraud. Because hedge funds are still lightly regulated, there is a greater chance of fraud than in the tightly regulated securities markets. Since hedge funds do not have to comply with the strict SEC disclosure rules that govern the public securities industry, their operations are relatively opaque — sometimes for good reasons, e.g., so competing funds can’t duplicate their strategies or bet against them. But such opacity makes it easier for managers to conceal losses or exaggerate reported profits in order to hike their fees. (All fund investors do receive annual financial audits, for tax purposes. Fund managers usually give their investors periodic performance reports, but they’re not required to do so.)

6. Investment in risky assets. Opportunistic fund managers may invest in almost any asset, anywhere. A 2009 survey by Greenwich Associates found that hedge funds made up 90% of trading volume in distressed debt. (Source: Coggan, op. cit., pg. 7)

7. Attrition risk. If a fund collapses, investors may have a hard time getting capital back out. A 2005 study by Burton G. Malkiel and Atanu Saha [“Hedge Funds: Risk and Return,” reported in Swedroe & Kizer, op. cit., pg. 189] found that less than 25 percent of the funds in existence in 1996 were still alive in 2004. Another study by Greg N. Gregoriou (“Hedge Fund Survival Lifetimes,” 2002, ibid.) found that the median residual lifetime of a hedge fund is 5.5 years. The history of hedge funds is littered with brilliant managers who managed, even without defrauding investors, to crash and burn brilliantly.

8. Agency risk. When a manager approaches the end of the year and has failed to reach the benchmark level above which he or she earns incentive compensation, he or she has an incentive to take large, even desperate risks to surpass the benchmark in a very short period. Whereas managers earn a percent of gains (over and above the benchmarks), they are not exposed to losses. Conversely, investors take all the downside risk but do not participate fully in the upside.

Do you need this excitement?

Back to the question, whether or not to invest in a hedge fund. The answer is, of course, it depends on your net worth, what’s in your portfolio already, long- and short-term goals, risk profile, liquidity needs, and other factors. Because of the high barrier to entry and the formidable risks, don’t make this decision without consulting a professional investment adviser who is experienced in accredited investor markets.

If you are still considering such an investment, the next steps are to (a) select a short list of funds that use investment strategies which are consistent with your portfolio needs, (b) conduct due diligence, and (c) before you select the fund to invest in, consider a fund of hedge funds to diversify the risk.

For additional resources, read these articles from AIMkts:

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About David M. Freedman

David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…

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