Given that hedge funds are an increasingly talked-about investment class, we thought we should provide you with our thoughts on hedge funds and the challenges of finding good ones...especially for the merely wealthy with less than $10m in assets.

The term hedge fund is a generic description which simply implies a private fund which can pursue multiple investment strategies and also employ substantial leverage (often without supervision by any regulatory body).  Generally, they charge both an ongoing management fee (often 2%) as well as an annual performance fee equal to share (often 20%) of a given year's profit.  There are many different types of hedge fund strategies, which include: absolute return, leveraged buy-out and private equity, global macro, equity long and short, convertible bond arbitrage, merger arbitrage, relative value, leveraged bond, etc....as well as a strategy known as Opportunistic...which just means that they do whatever they feel like and just try to make money (these are also referred to as multi-strategy).

For some investors there is definitely a place for hedge funds alongside traditional assets like stocks, bonds, real estate and cash.  Unfortunately, there has been a big push by most large investment firms to create hedge fund products for small investors, which tend to be expensive and not well managed.  Their promoters are often look to take advantage of the positive buzz around hedge funds over the past few years to earn large placement fees. 

The key issue when it comes to hedge funds is, "Do you have access to the good ones?"  For smaller investors with less than say $5m-$10m in assets to invest, the available alternatives are often very poor or untested.  Most hedge funds with a solid performance track record would not accept an investor with less than $500k - $1mn.  This is because there are strict limits to the total number of investors in each fund.

In order to profit from the allure of hedge funds, most big investment houses in the past few years have created products to sell to small investors who have been unable to gain access to hedge funds.  They normally are structured as a hedge fund-of-fund, which aggregates many small investors (say into a pool of $200m) then makes a meaningful investment into a number of other funds (say 20 different funds at $10mn each). These fund-of-funds will often borrow money in order to make larger investments with the same amount of investor capital, potentially enhancing returns (and fees) and also increasing the risk of loss.  These products often have very short performance track records and tend to have multiple levels of fees which can run from 3% to over 10% per year in total.  These funds are very illiquid and can be closed to redemption at the manager's discretion.  Also, there is little to no transparency into exactly what each fund owns. 

I have often heard these small-investor focused hedge funds pitched as a "risk lowering asset", because they are run with a conservative strategy and that in the aggregate the sum of all the different underlying investments will provide a consistent positive return in all markets...similar to a bond.  Given the very high fees and the risks associated with each individual hedge fund's investment strategy (which is usually unknown), in my opinion these small-investor fund-of-funds by design will return at most in the high single digits, and at worst a large loss.  Recent headlines have been filled with reports of catastrophic losses in just these types of hedge funds. 

We have access to quite a lot of funds...both fund-of-funds with low minimums (say $50k-$100k) and direct hedge fund investments (at higher minimums).  Also, I have had approximately 10 clients who have owned hedge funds from before we established our relationship.  I can say that not one of them has had a positive experience.

In the end, I advise our clients to avoid these products and instead choose high quality bonds as the tool to mitigate risk and provide returns uncorrelated to stocks.  With that said, this is an area that is changing rapidly and we expect that new and more interesting alternative investments will come to the market.  Stay tuned! 

Source:  Maxim Global Wealth Advisors, By Andrew Fisher, CFA, CPA - 2008
 

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