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Choppy Waters: Swimming With Hedge Funds

Hedge fund investors had good reason to be frustrated in 1998. First, despite the aura of risk reduction in which they cloak themselves, the funds took their customers on a roller-coaster ride during much of the year. Then many of the funds lagged the U.S. market recovery in the fourth quarter, turning what was on balance another good year on Wall Street into a debacle for the funds’ clients.

If all this was enough to make you swear off hedge funds and put your money in unmanaged stock indexes via the mutual funds that track them, you have pretty good reason. Stock index mutual funds have the twin virtues of being cheap to own and easy to understand. For many investors, index funds and other mutual funds can do the job, and hedge funds — which are available only to very well-to-do investors — are not an option anyway.

Still, as we discussed in our previous issue, hedge funds do offer opportunities to tap into financial strategies, markets and money managers that are not readily accessed through mutual funds. (See: Hedge Funds Can Reduce Risk While Causing Ulcers, in our November 1998 issue.) A carefully chosen hedge fund or two can even reduce the overall volatility of your portfolio.

The key phrase here is “carefully chosen.” You must understand what you are buying. If last summer’s financial collapse in Russia and the ensuing meltdown of Long-Term Capital Management demonstrated anything, it is that you would not want to have too much of your portfolio tied to a particular financial market or strategy no matter how shiny the market’s prospects or sterling the strategy’s pedigree. Your hedge fund should complement your portfolio, not dominate it.

Here are some questions that you or your investment adviser should ask if you are considering putting money into a hedge fund:

  1. How much leverage (i.e., borrowed money) does the fund currently use, and how much is the manager permitted to use under the fund’s partnership agreement? Leverage magnifies the profits — and losses — that a fund can generate, regardless of which strategies it uses. Because the opportunity for losses increases with leverage, highly leveraged funds stand a greater chance of seeing their investors’ stakes totally wiped out during adverse market conditions. A fund that uses more than a 2:1 debt-to-capital ratio should be considered highly leveraged, and you should accordingly limit your investments in such funds to a small portion of your total portfolio.
  2. What factors account for the fund’s performance in recent years? Often a fund manager will credit his global stock-research capabilities or her esoteric market-arbitrage strategy for a history of exceptional performance. When you look behind the claims, however, you may find that the performance was simply a matter of making leveraged bets in a favorable market. The problem is that such bets may amount to just being in the right place at the right time. We looked at one manager last year who used about a half-dozen different investment approaches and had a strong track record. We found that most of the investment strategies were only minor factors, and that this manager’s performance was, indeed, due to rising markets. When the stock indexes cratered, so did this manager’s performance. There is no substitute for reading, and understanding, the fund’s financial statements.
  3. Who has been auditing the financial statements, and for how long? If the fund recently switched to a name-brand accounting firm, but the performance record being touted goes back to a period when the fund manager’s college roommate was the auditor, be wary. A big accounting firm’s imprimatur is no guarantee, of course, but small firms rarely possess the geographic reach and depth of expertise needed to skeptically evaluate a large and wide-ranging portfolio.
  4. Do you understand what the hedge fund manager is currently doing? What assets are currently in the portfolio? How large are the long and short positions? What countries and currencies is the portfolio exposed to? Funds unwilling to reveal their strategy, and which ask you to buy their management simply on faith, are the proverbial pig in a poke. Act accordingly.
  5. What happens when you want to get out of the fund? Ironically, even though some hedge funds are very active short-term traders, they do not permit investors who do not come aboard for the long haul. Most therefore impose a lockup period during which you will not be allowed to withdraw. While this is important, to give the fund manager enough stability to execute his or her strategy, you may not want to accept a lockup of more than one year.
  6. How often can you get out? Hedge funds typically permit quarterly withdrawals with 30 days advance notice, but be careful. Some arrangements allow the fund manager to disallow any withdrawals that do not occur on December 31.
  7. How expensive is the fund? Typical fee structures are a 1% management fee, plus an incentive fee of 20% of the profits. That 20% is a hefty cut if the manager only delivers what you could have gotten from more pedestrian alternatives. A more reasonable approach is for the manager to take the incentive fee only when positive returns exceed a predetermined benchmark.
  8. Is the fund manager a major investor in the fund? Does he or she put a substantial portion of his personal net worth in the fund? While this kind of personal exposure hardly guarantees success, it is a pretty good bet that the manager’s attention will not wander very far.
  9. How consistent has the performance record been? If 1996 and 1997 were great years, but 1998’s returns were sub-par, the fund’s 3-year annualized return can still be extremely high. Focusing on the three-year average could lead you to overlook warning signs that were brought to the surface in the market turmoil of 1998.
  10. How does the fund correlate with a suitable benchmark? If the fund has a 100% correlation to the S&P 500 Index, why not buy the index? It will be a cheaper and surer performer. If the idea of a hedge fund is, in fact, to hedge your market risk by diversifying, you probably would want to avoid a fund that is highly correlated to other holdings that are well represented in your portfolio.

If you enjoyed this article, be sure to check out Palisades Hudson’s books, The High Achiever’s Guide To Wealth and Looking Ahead: Life, Family, Wealth and Business After 55. Both are available in paperback and as e-books.