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For Dummies is a registered trademark of Wiley Publishing, Inc. in the United States and other countries. Used here by license. Is a hedge fund a surefire way to expand your wealth or a scam that will surely rip you off? Is it a newfangled mutual fund or a scheme for raiding corporations and ripping off hard-working employees? You see hedge funds in the news all the time, but it’s hard to know exactly what they are. That’s because, at its essence, a hedge fund is a bit of a mystery. A hedge fund is a lightly regulated investment partnership that invests in a range of securities in an attempt to increase expected return while reducing risk. And that can mean just about anything. Some of the smartest money managers on Wall Street have started their own hedge funds, attracted by the freedom to manage money as they see fit while raking in good money for themselves and their investors in the process. Hedge fund managers today take on the roles of risk managers, investment bankers, venture capitalists, and currency speculators, and they affect discussions in boardrooms at brokerage firms, corporations, and central banks all over the world. In this article, I cover the basic vocabulary and structure of hedge funds. Having this knowledge helps you understand hedge funds so that you can figure out what you need to know in order to make the best decisions with your money. Also, I clarify what a hedge fund is and what it isn’t, which is important because you come across a lot of myth and misinformation out there. The information you find here serves as a springboard for the topics I introduce throughout the rest of the section, so get ready to dive in.
Defining Hedge FundsHere’s the first thing you should know about hedge funds: They have no clear identity or definition. In the investment world, “I run a hedge fund” has the same meaning as “I’m a consultant” in the rest of the business world. The speaker may be managing money and making millions, or she may want a socially acceptable reason for not having a real job. The person who really manages money may go about her business in any number of ways, from highly conservative investing to wildly aggressive risk taking. She may be beating the market handily, or she may be barely squeaking by. I’m not trying to say that the term “hedge fund” means nothing. Here’s the short answer: A hedge fund is a lightly regulated investment partnership that uses a range of investment techniques and invests in a wide array of assets to generate a higher return for a given level of risk than what’s expected of normal investments. In many cases, but hardly all, hedge funds are managed to generate a consistent level of return, regardless of what the market does. Before I get to the longer, more complicated explanation of hedge funds, however, it helps to know exactly what hedging is.
HedgingHedging means reducing risk, which is what many hedge funds are designed to do. Maybe you’ve hedged a risky bet with a friend before by making a conservative bet on the side. But a hedge fund manager doesn’t reduce risk by investing in conservative assets. Although risk is usually a function of return (the higher the risk, the higher the return), a hedge fund manager has ways to reduce risk without cutting into investment income. She can look for ways to get rid of some risks while taking on others with an expected good return, often by using sophisticated techniques. For example, a fund manager can take stock-market risk out of the fund’s portfolio by selling stock index futures. Or she can increase her return from a relatively low risk investment by borrowing money, known as leveragin. If you’re interested in investing in hedge funds, you need to know how the fund managers are making money. Risk remains, no matter the hedge-fund strategy, however. Some hedge funds generate extraordinary returns for their investors, but some don’t. In 2005, the Credit Suisse/Tremont Hedge Fund Index — a leading measure of hedgefund performance (www.hedgeindex.com/hedgeindex/en/default. aspx) — reported that the average hedge-fund return for the year was 7.61 percent. The NASDAQ Composite Index (www.nasdaq.com) returned only 1.37 percent for the same period, but the Morgan Stanley Capital International World Index (www.mscibarra.com) was up 10.02 percent. The amount of potential return makes hedge funds more than worthwhile in the minds of many accredited and qualified investors (see Chapter 2 for more on hedgefund requirements). In 2005, 9,000 hedge funds managed a total of $1 trillion dollars, according to Hedge Fund Research, a firm that tracks the hedge-fund industry (www. hedgefundresearch.com). In 2005, therefore, the average fund had $111 million in assets. Given the industry’s standard fee structure, in which managers charge at least 1 or 2 percent of assets, the typical fund generated $1.1 to $2.2 million on the year for the fund manager. Return is a function of risk. The challenge for the hedge fund manager is to eliminate some risk while gaining return on investments — not a simple task, which is why hedge fund managers get paid handsomely if they succeed.
Identifying hedge fundsOkay, I’ll go ahead and start covering the gory details of hedge funds. A hedge fund is a private partnership that operates with little to no SEC regulation. A hedge fund differs from so-called “real money” — traditional investment accounts like mutual funds, pensions, and endowments — because it has more freedom to pursue different investment strategies. In some cases, these unique strategies can lead to huge gains while the traditional market measures languish. The following sections dig deeper into the characteristics of hedge funds, as well as the bonuses that come with funds and the possibility of bias in the reported performances of funds.
Little to no regulatory oversightHedge funds don’t have to register with the U.S. Securities and Exchange Commission (SEC). The funds and their managers also aren’t required to register with the National Association of Securities Dealers (NASD) or the Commodity Futures Trading Commission, the major self-regulatory bodies in the investment business. However, many funds register with these bodies anyway, choosing to give investors peace of mind and many protections otherwise not afforded to them (not including protection from losing money, of course). Whether registered or not, hedge funds can’t commit fraud, engage in insider trading, or otherwise violate the laws of the land. In order to stay free of the yoke of strict regulation, hedge funds agree to accept money only from accredited or qualified investors. Accredited investors are individuals with a net worth of at least $1 million or an annual income of $200,000. Qualified investors are individuals, trust accounts, or institutional funds with at least $5 million in investable assets. The reason for the high-net-worth requirement is that regulators believe people with plenty of money generally understand investment risks and returns better than the average person, and accredited investors can afford to lose money if their investments don’t work out. In order to avoid the appearance of improper marketing to unqualified investors, hedge funds tend to stay away from Web sites, and some don’t even have listed telephone numbers. You have to prove your accredited status before you can see offering documents from a fund or find out more about a fund’s investment style.
Aggressive investment strategies
In order to post a higher return for a given level of risk than otherwise expected, a hedge fund manager has to do things differently than a traditional money manager. This fact is where a hedge fund’s relative lack of regulatory oversight becomes important: A hedge fund manager has a broad array of investment techniques at his disposal that aren’t feasible for a tightly regulated investor. Here are a few investment techniques that I cover in great detail:
Short-selling: Hedge fund managers buy securities that they think will go up in price. If they spot securities that are likely to go down in price, they borrow them from investors who own them and then sell the securities in an attempt to buy them back at lower prices in order to repay the loans.
Leverage : Hedge funds borrow plenty of money in order to increase return — a technique that can also increase risk. The fund has to repay the loan, regardless of how the investment works out. The use of leverage is a key difference between hedge funds and other types of investments. Most hedge funds rely on leverage to increase their returns relative to the amount of money that they have in their accounts. Because of the risk that comes with the strategy, funds often use leverage only for low-risk investment strategies in order to increase return without taking on undue risk.
The Buffet Line: Okay, so I made this one up. But hedge fund managers do have a wide range of investment options. They don’t have to lock in to stocks and bonds only. They buy and sell securities from around the world, invest in private deals, trade commodities, and speculate in derivatives. They have flexibility that traditional asset managers only dream about.
Manager bonuses for performance
Another factor that distinguishes a hedge fund from a mutual fund, individual account, or other type of investment portfolio is the fund manager’s compensation. Many hedge funds are structured under the so-called 2 and 20 arrangement, meaning that the fund manager receives an annual fee equal to 2 percent of the assets in the fund and an additional bonus equal to 20 percent of the year’s profits. The performance fee is a key factor that separates hedge funds from other types of investments. U.S. Securities and Exchange Commission regulations forbid mutual funds, for example, from charging performance fees. You may find that the percentages differ from the 2 and 20 formula when you start investigating prospective funds, but the management fee plus bonus structure rarely changes. The hedge fund manager receives a bonus only if the fund makes money. Many investors love that the fund manager’s fortunes are tied to theirs. The downside of this rule? After all the investors pay their fees, the hedge fund’s great performance relative to other investments may disappear.
Biased performance data
What gets investors excited about hedge funds is that the funds seem to have fabulous performances at every turn, no matter what the market does. But the great numbers you see in the papers can be misleading. Hedge funds are private investment partnerships with little to no regulatory oversight, which means that fund managers don’t have to report performance numbers to anyone other than their fund investors. Many hedge fund managers report their numbers to different analytical, consulting, and index firms, but they don’t have to. Naturally, the funds most likely to participate in outside performance measurement are the ones most likely to have good performance numbers to report — especially if the fund managers are looking to raise more money. On the other end of the success spectrum, many hedge funds close shop when things aren’t going well. If a fund manager is disappointed about losing his performance bonus, he may just shut down the fund, return all his investors’ money, and move on to another fund or another project. Hedge Fund Research, a consulting firm that tracks the industry (www. hedgefundresearch.com), estimates that 11.4 percent of hedge funds closed in 2005. After a fund shuts down, it doesn’t report its data anymore (if it ever did); poorly performing funds are most likely to close, which means that measures of hedge-fund performance have a bias toward good numbers. You have to do your homework when buying into a hedge fund. You can’t rely on a rating service, and you can’t rely on the SEC, as you can with a mutual fund or other registered investment. You have to ask a lot of tough questions about who the fund manager is, what he plans for the fund’s strategy, and who will be verifying the performance numbers.
Acquiring hedge fund information
Some hedge funds are very secretive, and for good reason: If other players in the market know how a fund is making its money, they’ll try to use the same techniques, and the unique opportunity for the front-running hedge fund may disappear. Hedge funds aren’t required to report their performance, disclose their holdings, or take questions from shareholders. However, that doesn’t mean hedge fund managers refuse to tell you anything. A fund must prepare a partnership agreement or offering memorandum for prospective investors that explains the following:
The fund’s investment style
The fund’s structure
The fund manager’s background
A hedge fund should also undergo an annual audit of holdings and performance and give this report to all fund investors. (The fund manager may require you to sign a nondisclosure agreement as a condition of receiving the information, but the information should be made available nonetheless.) But the hedge fund manager doesn’t have to give you regular and detailed information, nor should you expect to receive it. Beware the hedge fund that gives investors no information or that refuses to agree to an annual audit — that’s a blueprint for fraud.
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For Dummies is a registered trademark of Wiley Publishing, Inc. in the United States and other countries. Used here by license.