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I spent some time with Andrew Horowitz from The Disciplined Investor this week and we had a conversation about hedge funds and their role in our current investment environment.  He asked me to write a brief post on what hedge funds really are and what investors should look for when considering investing.

It’s actually a bit difficult to come across a widely accepted definition of “hedge fund,” but most in the industry use the term to define a private mutual fund whose management is compensated to at least some degree on performance rather than just on a fee basis.  Often a fund of this type will charge investors a 2% management fee and then will also receive 20% of profits at the end of each year. 

A hedge fund can invest in any number of strategies or securities and range from ultra-conservative vehicles to extremely risky “cowboy” type traders.  So when hearing the word “hedge fund” one should think much less of a strategy for investing, and more of a legal or structural type of investment structure.

One of the main reasons a hedge fund investment may be appropriate is for diversification.  If one has $1.5 million in a retirement account that is tracking closely to the S&P 500, it may make sense to employ a hedge fund that uses a strategy that is very different from a long-only indexed manager.  That way if we experience a weak economic period, a different type of investment strategy may actually have an unusually positive period.  This would allow a large investor the chance to spread his exposure to different types of risk so that not all of his wealth is experiencing the same declines (or advances).

While many claim that performance fees are excessive, investors should look at their net return after all fees and compare them to an applicable benchmark.  For instance, if a hedge fund manager returns 20% in a given year after all fees are deducted and the market is only up 10%, then investors may be willing to overlook the excessive fees because they received a superior rate of return.  If over the long-term this manager has more risk and does not give investors a superior return after fees, then an argument that he is overpaid is probably legitimate.  

Another argument is that the performance fee gives the manager an incentive to be more risky as he will benefit from strong returns, but has little to lose if he is wrong.  This is why it is especially important for investors to expect a hedge fund manager to have a personal stake in the fund so that he feels the same pain of losing if he is unwise with his decisions.

No discussion of hedge funds would be complete without a discussion of risk and leverage.  Some of the more notable hedge funds have used leverage, which means the fund is investing borrowed money.  Imagine a fund which receives $100 million of capital from investors and then borrows an additional $400 million to be able to invest more capital.  The fund is now leveraged four to one.  So now if the $500 million total assets are invested and experience a 20% increase, investors would have doubled their money (the $500 million is increased to $600 million - take out the $400 in debt and you have $200 left which doubles the initial investment). 

While this scenario is incredibly exciting, the reverse scenario is even more disturbing.  If the $500 million experiences a 20% loss, the loss is $100 million which leaves investors with absolutely nothing after paying back the debt.  So anyone looking at investing in a hedge fund should be acutely aware of what leverage is being employed.

Finally, the SEC requires most true hedge funds to be marketed only to accredited investors.  To fit this description, an investor must have $1 million of investable assets or have an annual income greater than $200,000.  The rationale behind this rule is that since these funds are typically not regulated as strictly as mutual funds, the SEC does not want investors to be duped into a fund where they do not understand what risks are being taken. 

While wealth is certainly not a determinant of knowledge or wisdom, it is more acceptable for a millionaire to lose a few hundred thousand in a poor decision than for an ill-informed person to lose his or her entire life savings because he or she did not understand the fund.

So the hedge fund industry certainly has its strengths and weaknesses, but the bottom line is that each fund should be judged individually and investors should always perform due diligence on their investors no matter what type of vehicle they are dealing with.

Source: Are Hedge Funds Good or Bad? Is That the Right Question?