FEAR NOT ALL HEDGE FUNDS (BW 12/14/1998)
If you're thinking about investing in a hedge fund, a good starting point is to study Long-Term Capital Management. Then run in the other direction. For most investors, the characteristics of the ideal fund are the opposite of those of Greenwich (Conn.)-based LTCM, whose leveraged bets went so bad that its bankers had to take it over in September, injecting $3.6 billion.
Contrary to popular impressions, hedge funds aren't just for risk-hungry investors who sky-dive on weekends. Sure, there are funds that use lots of borrowed money to juice up their bets. But others use little or no leverage. And many pursue investing strategies aimed at low volatility, even if that means accepting lower returns. ''People think of hedge funds generically but there is a very big difference in the ways they control risk,'' says John Taylor, a managing director at Goldman Sachs.
BRUTAL YEAR. As LTCM founder John Meriwether and other battered
hedge-fund pros can attest, 1998 has been a brutal year for most of the industry. The EACM 100 hedge-fund index, compiled by Norwalk
(Conn.)-based consultant Evaluation Associates Capital Markets, was down 2.5% through Oct. 31 vs. a 13% rise for the Standard & Poor's 500-stock index.
Over the long term, though, hedge-fund performance has been better.
According to a study this year by Goldman Sachs and London-based
Financial Risk Management, a typical fund produces returns approaching those of the S&P 500, yet with smaller fluctuations. The study covered a representative selection of 277 funds from 1993 through 1997. For instance, so-called ''market-neutral'' funds, which try to exploit pricing anomalies between related securities, had an annualized return of 13.4% and a standard deviation of 1.86. (Standard deviation is a measure of volatility, and the lower, the better.) Over the same period, the S&P 500 returned 20.3% annually, but with a standard deviation of 10.7. Indeed, Managed Account Reports, a New York financial-research group, lists four funds whose standard deviation was below 1 for all of 1997 and again this year through
Oct. 31: Argent Classic Convertible Arbitrage and its Bermuda-based
cousin for offshore investors; Gems Opportunity Fund; and CDC Gamma
Fund, biggest of the four with $1 billion in assets.
Picking a low-volatility hedge fund isn't the only way to reduce risk. Another way is to diversify by purchasing several hedge funds that aren't low in risk but exhibit low volatility when you look at them together. The key is that they must have different investing styles, so they don't move up and down in lockstep. Hedge funds operate in dozens of exotic styles that aren't easily available elsewhere, from investing in distressed securities to participating in venture-capital financing. So the hedge-fund world offers you greater opportunities for diversification than if you restrict yourself to stocks and bonds.
Most advisers say the optimum number of hedge funds for the sake of
diversification is around seven. If you can't afford that many, a good
alternative is a fund that invests in hedge funds. The main drawback is that a fund-of-funds manager will usually charge 1% of assets on top of the hedge funds' own fees. Some also charge a share of any profits. Two top-performing funds of funds with relatively low volatility are Arden Advisers' offering, with an annualized return of 13.5% in the four years through Sept. 30, and Dillon Flaherty Market Neutral Fund, with a 12.5% return.
However you pick your fund, you have plenty to choose from. Some 4,000
funds, domestic and offshore, now manage about $400 billion in assets. Hedge funds are largely unregulated on the theory that the rich can look out for themselves. They're usually structured as limited partnerships in which managers receive a substantial share of any profits. Minimum investments range from $100,000 to $20 million--but the typical amount is $1 million. You're obliged to commit your money for a minimum period, up to several years. That gives managers breathing room to attempt long-range strategies, although some have been forced to raise cash lately in expectation of large redemptions sparked by the market's recent volatility.
Only 1.5% of U.S. families qualify to invest in hedge funds. That's because federal law limits most hedge funds to no more than 99 limited partners with steady annual incomes of $200,000 or more or a net worth of $1 million, excluding their home. Funds can have up to 499 limited partners if each has $5 million in invested assets. Many hedge funds, such as Julian Robertson's Jaguar Fund and all of George Soros' hedge funds, are domiciled offshore and are not open to U.S. citizens. But other Robertson funds are open to Americans.
In selecting a fund, make sure the general partner has a lot of his or her wealth--preferably 40% or more--invested in it. Examine its track record through market cycles. Says Robert Schulman of Tremont Advisers in Rye, N.Y.: ''We're interested in people who have shown a combination of will and skill to stay in business.''
As with mutual funds, hot historic results are no guarantee of future returns. ''That's the biggest trap. You may be buying after the opportunity is pretty much gone,'' says Joseph Nicholas, CEO of Chicago's Hedge Fund Research and author of a forthcoming Bloomberg Press book, Investing in Hedge Funds. Also, beware of high fees. The typical fund charges a 1% annual asset-management fee, plus 20% of profits.
Hedge funds are now being offered by mutual-fund companies such as
Alliance Capital Management, Franklin/Templeton Investor Services, and
Gabelli Funds, and by banks and brokers such as State Street, J.P. Morgan, and BancAmerica Robertson Stephens. They generally sell only their own house funds.
It's also possible to mimic the strategy of some hedge funds without getting into a hedge fund at all. A tax-law change last year made it easier for mutual funds to sell shares short, so they can replicate the ''long-short'' strategy that many equity hedge funds follow: buying some stocks and shorting others so the portfolio is somewhat immunized from swings in the overall market. The $300 million Barr Rosenberg Market Neutral mutual fund is an example. (It was down 1.9% from its inception last Dec. 16 through this October.) Market-neutral mutual funds don't skim off a share of the profits, and their asset-management fees--2% to 2.5%--aren't much higher than the 1% asset-management fees typical of hedge funds.
LEGWORK. You can invest in the funds by contacting a fund directly or a brokerage firm that offers hedge funds. But for thoroughness, consider using a consultant such as Hedge Fund Research (312 658-0955), New York-based Hennessee Group (212 857-4400), or Van Hedge Fund Advisors International of Nashville, Tenn. (615 377-2949). They charge about 1% of invested assets as a fee for assembling a portfolio that meets your needs. Some consultants accept payments from the funds themselves, but then you're not sure you're getting unbiased advice. You can also do your own legwork by getting data from Hedge Fund Research, which charges $6,000 a year for performance data, updated monthly, on the 1,400 or so funds that take new investors. Managed Account Reports (212 213-6202) also charges $6,000 for a similar product.
Hedge funds are certainly for big players--folks who need wide diversification and are comfortable with specialized investments. But the funds aren't necessarily nitroglycerine, no matter what the headlines say.
By Peter Coy
EDITED BY AMY DUNKIN
Copyright 1998, by The McGraw-Hill Companies Inc. All rights reserved. |
