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Hedge Funds Can Reduce Risk While Causing Ulcers

Until recently, hedge funds were seen as cash machines for institutions and weal thy individuals. In some circles today, the term “hedge fund” may mean the quickest way to destroy wealth without using a bonfire or a shredder. But what is a hedge fund really, should an investor consider one, and how do you perform some reasonable due diligence?

The “hedge fund” label is applied these days to the multitude of private partnerships that are aimed at very well-heeled investors. Some of these funds actually use hedging strategies to reduce risk. Others do not. Many, whether using hedging or not, also use leverage, which as most readers know will usually increase the level of risk and the potential rewards.

If I were losing sleep about a return of high inflation, I might hedge by buying futures contracts on crude oil. My logic would be that if inflation should return to levels of the Jimmy Carter era, oil prices and the value of my futures would rise accordingly, offsetting a likely decline in my stock portfolio. While I am confident my stock portfolio will increase over the long haul, the presence of my inflation hedge could make me feel more secure during a period of high inflation and poor stock performance.

Hedge funds can invest in virtually anything, virtually anywhere. They can hold stocks, bonds, and government securities in all global markets. They may purchase currencies, derivatives, commodities, and tangible assets. They may leverage their portfolios by borrowing money against their assets, or by borrowing stocks from investment brokers and selling them (shorting). They may also invest in closely held companies.

Since hedging is an attempt to protect against downside risk, there is a hedge fund for any sort of pessimist. Common hedge fund strategies are macro (global), emerging markets, market neutral, distressed securities, arbitrage, short selling, fund of funds, opportunistic (multi-strategy), special situation (event-driven), and sector. A description of each appears in Figure 1.

 Macro (Global)Seeks profits from changes in the global economy. Such changes include shifts in currency and global interest rates. Use of leverage and derivatives is common.
Emerging MarketsInvests in debt and equity instruments of less mature financial markets. Near top in risk/reward potential.
Market Neutral

Buys (long) and sells (short) similar dollar amounts of stocks attempting to remove market risk. Success depends upon stock picking ability

Distressed SecuritiesPurchases debt and equity instruments of companies in financial difficulty or bankruptcy.
ArbitrageBets large amounts on price inefficiencies in stock, bond, and/or currency markets. 
Short-SellingSells (shorts) borrowed shares in anticipation that they will decrease in value.
Fund of Funds Fund that invests in several hedge funds. May require lower minimum investment than would direct investment in underlying holdings.
Opportunistic (multi-strategy) Uses several investment strategies to capitalize on most profitable opportunities.
Special-Situation (Event-Driven)Investments made in reaction to or anticipation of events unrecognized by the market.
SectorInvests in specific industries or sectors.

Table 1

Hedge funds are not registered as publicly traded securities. For this reason, they are available only to buyers who meet the Securities and Exchange Commission definition of “accredited investors.” Accredited investors who are individuals must have a net worth exceeding $1 million or have an income greater than $200,000 ($300,000 for couples) in each of the previous two years prior to the investment with a reasonable expectation of sustainability. Institutional investors, such as pension plans and limited partnerships, have higher minimum requirements. The SEC reasons that these investors have financial advisers or are savvy enough to evaluate sophisticated investments for themselves.

Some investors use hedge funds to reduce risk in their portfolio by diversifying into uncommon or alternative investments like commodities or foreign currencies. Others have begun to use hedge funds as the primary means of implementing their long-term investment strategy. The performance of some hedge funds is the reason behind the trend toward using these funds as a general investment tool rather than simply as a risk reducer. According to Van Hedge Fund Advisors International, the average annualized returns of the Emerging Markets, Opportunistic, and Special-Situation hedge fund styles outperformed both the S&P 500 index and the Morningstar Average Equity Mutual Fund for the five-year period ended December 31, 1997. The Emerging Markets hedge fund style returned 20.5%, the Opportunistic style returned 21.7%, and the Special-Situations style had a return of 21.0%, while the S&P 500 index returned 20.3%, and the average equity mutual fund at Morningstar returned 14.9%.

A hedge fund home run can be just as spectacular as the Mark McGwire variety. For instance, in 1995 the Quota Fund N.V., part of George Soros’ Quantum Fund group, returned (in U.S. dollars) 159.4% net of fees. In subsequent years, Quota Fund N.V.’s returns were 81.9% and 49.3%, net of fees. Before you write your check to Quota Fund, note that this fund is only open to non-U.S. citizens and residents. Recall also that more recently, Russian investments cost Soros’ a reported $2 billion. As a hedge, this certainly is not the place to run when the world’s stock markets are on fire. (Editor’s Note: As we went to press, Soros announced that Quota’s principal adviser, Nicholas Roditi, is leaving on a “temporary medical leave of absence.”)

How did hedge funds fare during this year’s stormy third quarter? August was one of the most volatile months in stock market history, with the S&P 500 index down 14.5%. Most hedge fund groups outperformed the index, according to Van. Results appear in Figure 2.

International. Figures are in Table 2.

S&P 500-index -14.5%
Macro (Global)     2.0%
Emerging Markets -18.9%
Market Neutral (Securities Hedging)    -1.4%
Distressed Securities  -3.5%
Market Neutral (Arbitrage)     -1.0%
Short-Selling  29.1%  
Fund of Funds    -5.1%
Opportunistic     -7.9%
Special-Situation (Event-Driven)  -8.0%  
Sector    n/a  

 Table 2

If hedge funds did relatively well overall, what happened at Long Term Capital Management? This fund burst into the headlines when it required a $3.6 billion bailout from prominent banks and brokerage houses that had already lent it billions more. LTCM, run by the former head bond trader and vice chairman of Salomon Brothers, a former vice chairman of the Federal reserve, and two Nobel Prize-winning economists, leveraged almost $5 billion into a $100 billion portfolio full of derivatives, a 20-1 leverage ratio.

The results were spectacular while LTCM’s strategy worked, and were equally spectacular (and disastrous) this summer, when it didn’t. Few of LTCM’s investors and perhaps none of its lenders were aware of the magnitude of this fund’s gambles. In fact, I have read that it took a $100 million investment before LTCM would divulge its investment strategy. Call me old-fashioned, but I like to know what I’m buying before I buy it.

If, as they say in the mutual fund literature, “past results are not indicative of future performance,” how should one go about evaluating a hedge fund? As with any other investment portfolio, the key is to understand the types of investments it currently owns, the overall strategy of the manager, and the tactics the manager intends to use or avoid. Getting answers to these questions is not only due diligence, but common sense.

A very popular Macro (Global) fund is the Tiger Fund, the original hedge fund offering of investment mastermind Julian Robertson and his Tiger Management LLC. Tiger Fund’s returns through the end of 1997 were outstanding. The hedge fund returned better than 30% annually for its 1, 3, 5, and 10-year periods, net of fees. In August the Tiger Fund proved to be a genuine risk reducer, finishing with a 1% gain, 15.5% better than the S&P 500. But as the markets recovered in September and October, Julian Robertson and Tiger Management — which includes Tiger Fund and a number of siblings — began to lose ground. On October 9, 1998, Tiger Management lost $2 billion (9%) when the value of the Japanese yen abruptly strengthened against the U.S. dollar. True, a hedge fund with a low correlation to the S&P 500 is attractive, but with the volatility experienced in October, this is a “risk reducer” that may make some investors queasy.

Obviously, some fund strategies are much riskier than others. Even funds using the same strategy may have greatly different levels of risk, depending upon the techniques that the manager chooses to use, and particularly the degree of leverage that the fund employs. In our next issue, we will take a closer look at the safer and riskier breeds of hedge funds, and at the questions you should ask when the sales rep calls. Click here to read, “Choppy Waters: Swimming With Hedge Funds.”