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By Joseph Hogue, CFA

A friend tipped me off to the upcoming documentary, “Chasing Madoff,” detailing the uncovering of the biggest hedge fund scheme in history. Hedge funds have always been something of a mystery among the general investing public. The majority of investors do not meet the net worth requirements to invest in these assets, at least $750,000 of assets under management or a net worth of more than $1.5 million. Those lucky few are introduced to a world of increased diversification and higher risk-adjusted returns when compared to traditional portfolios of stocks and bonds.

There are downsides, as evidenced by the nearly $50 billion blow-up in the Madoff fund. The industry is largely unregulated, giving fund managers an extreme amount of discretion with investor assets. With these risks, given the opportunity to invest in a hedge fund, would the average investor even want to do so?

Hedge funds, as a group, have historically achieved a higher return than stocks or bonds. The table below shows the performance and volatility of the most popular hedge fund strategies for the period 1990-2004. The table also shows the strategies’ correlations with stocks and bonds, providing a level of diversification when added to a traditional portfolio. Stocks are represented by the S&P 500 index and returned 8.9% on an annualized basis, while bond performance is from the Lehman Government/Corporate Bond index. The composite performance for hedge funds is presented through the Hedge Fund Composite Index (HFCI). Whether you agree with the unregulated nature of hedge funds, the data presents a strong case for hedge fund exposure as a strategic part of your asset allocation.

Because they are not open to the general public as retail investments, hedge fund managers do not have the same regulatory reporting requirements as do traditional advisors and fund managers. This has allowed a few managers, Madoff et al., to abscond with investors’ money. Despite the 24/7 media coverage, these incidences comprise an amazingly rare occurrence within the hedge fund universe. Even after the shakeout of 2008, there were 6,800 hedge funds tracked by the industry tracker Hedge Fund Research. The Dodd-Frank bill, enacted but yet to be implemented, requires hedge funds and private equity firms to register with the SEC. With the speed at which the bill is moving, I am not basing any decisions off of Dodd-Frank.

Whereas most fund investments rely on a specific strategy, hedge funds are a skill-based strategy depending heavily on the skill of the particular manager. Additionally, most hedge funds include a lock-up period meaning investors must keep their investment in the fund for at least 3-5 years. Most hedge funds charge a base fee of about 1.5% of assets and an incentive fee of around 20% of profits. Much of this is avoided with exchange traded funds (ETFs) however, as they use rules-based strategies to mimic those employed by managers and can be bought or sold like regular stocks.

Hedge funds can vary considerably by investment style. Traditionally, they were set up as primarily market neutral strategies, but have expanded into just about every style imaginable. Fixed-income arbitrage involves taking advantage of yield curve changes and rate spreads through long and short positions in debt. Global macro strategies take broad-asset positions in derivatives and currencies instead of individual securities. Equity hedge strategies represent the largest style by assets under management. The strategy takes long and short positions in individual securities deemed to be over- or undervalued. Not all equity hedge strategies invest to be market neutral and can be net long or net short.

ETFs provide a particularly appealing opportunity to the average investor seeking exposure to hedge fund strategies. ETFs representing traditional investing strategies can help investors gain exposure to many securities with one purchase, but most are fairly easily replicable through direct stock purchases. Hedge fund ETFs replicate the extremely complicated world of arbitrage and hedging, something the majority of investors would have a hard time doing on a daily basis. Many of the exchange traded funds trade on a rules-based strategy and do not have risk exposure to a particular manager.

The IQ Hedge Multi-Strategy Tracker (QAI) attempts to replicate the risk-adjusted returns of hedge funds using an aggregation of styles including: long/short equity, global macro, market neutral, event-driven, and fixed-income arbitrage. The fund has returned 4.5% in the past year, outperforming the S&P500 by approximately one percent. The fund does not actually invest in hedge funds but tracks a rules-based index. This allows it to provide a hedge fund strategy but includes no manager-specific risk. The fund holds a broad range of asset classes with bonds comprising a little over half (51.3%) of the fund. The fund’s expense ratio is .75% but also charges .38% in other fees for a total operating expense of 1.13%. Maximum drawdown, a measure of risk by which hedge funds are typically measured, is the largest decline between two periods. The max drawdown for the QAI since inception was -7.9% versus a drawdown of the S&P500 of -36.1% for the same period.

The Credit Suisse Merger Arbitrage Liquid ETN (CSMA) seeks to take advantage of price differences between target and acquirer firms during merger deals. The fund typically invests in the target and takes a short position in the acquirer and profits as deal terms are detailed. Merger-arbitrage funds are usually market neutral, meaning the returns to the strategy do not depend on directionality of the market. The fund’s maximum drawdown for the ten years to December 2009 was 11.65%. Like most hedge fund strategies, the fund carries an extremely low correlation with the S&P500 of .37 making it a valuable portfolio diversifier. The fund has returned about 2.2% over the last twelve months and charges an annual fee of .55% of assets.

The WisdomTree Managed Futures Strategy (WDTI) seeks to provide investors with positive returns given any market direction. The fund invests in a diverse array of assets including: treasury futures, currency swaps and futures, commodity swaps and futures, and money market securities. For some time, managed futures have been used by institutional investors to achieve portfolio diversification and returns regardless of market direction. The fund’s expense ratio is .95% and has returned .72% since its inception in January of this year. About half of the funds holdings are within commodity instruments while the other half is divided between other financial instruments, i.e. rate instruments and currency instruments.

The table below shows the correlations for each of the above funds with the SPDR S&P 500 (SPY) representing the broader market of large-cap stocks. While the multi-strategy fund provides the highest level of diversification, the other two funds also have low correlations to the index.

Frankly, like many investors, I have always been skeptical of hedge funds and their unregulated managers. SEC and FINRA oversight, while not perfect, provides a level of confidence that other fund managers do not have carte blanche with my money. As a rational investor, I should not let the actions of a handful of managers out of 6,800 plus funds keep me from taking advantage of strategies that provide excellent risk-adjusted returns and diversification. Exposure to hedge fund return and risk characteristics is an integral part of a diversified asset allocation. The funds above are good choices, but not the only ones. Investors need to do their own due diligence and research the strategies within each fund to decide which will provide the best fit for their own portfolio.

Source: Getting Your Hedge Fund Allocation While Avoiding The Next Madoff