Hedge funds are going mainstream. If you've heard the term 'hedge fund' but never wondered aloud, lest your ignorance show, here's the update on what's new in that secretive world. Billed as the Billionaire's Secret to Investing, participating in hedge funds (HFs) is the new average guy's avenue to bragging rights. Used to be that the HF world belonged to those who demonstrated some level of investment competency, measured by your net worth and income levels. Those folks were referred to in investment parlance as 'Accredited Investors'. Since the risks involved in HF investing were touted as extreme, then, only those who could understand the doorstop pile of paperwork required as entry, were invited to play. And if you lost it all, supposedly, your other more 'serious' assets would allow you to recoup and move on.
Well, tell that to those who invested not only personal money but major amounts of pension money in a little known company called Long Term Capital Management which collapsed in 1998. The collapse sent ripple effects into the economy that was stopped only by the largest brokerage firms in NYC in a brokered deal by the Feds. Since then, the term Hedge Fund has come to be a proxy for secretive, bad dealing con artists who have taken the old Ponzy Scheme to new lows. And every once in a while, another one or two pops up and confirms the validity of that reputation.
Why then would those of us who do not have millions to spare be interested in playing in this high stakes world? The simplest answer is: higher-than-average returns. The more complex answer is that it allows for participation in markets and asset classes that most of us don't even know exist; asset classes like Asian junk bonds, and Special Situations funds. If you are fearful of putting all your eggs in one basket ala Long Term Capital Management, you can now spread that risk by investing in a HF that is composed of several, sometimes 10 or more, HFs, called a Fund-of-Funds. The theory is that having money managers that have performed admirably in difficult market situations and outperformed their peers in even bad markets coupled with a few real losers will help you be in the right place at least some of the time.
How would you know if you are a candidate for this type of investment? Like every lawyer says, 'it depends'. There is a provision for those who are not accredited investors to participate, but you must sign off and offer your first born to play. Basically you swear that you are a sophisticated investor with knowledge of the markets and of the elements of risk you are assuming by being in this fund. Translation: you won't sue them if you lose all your money. And if you can attest to that, then you can play. But don't expect a monthly statement like you get from the brokerage houses. If you get a quarterly statement, consider yourself lucky. Most HFs give annual statements to show you how much you invested, how much your interest is worth today, and how much you would get for your interest if you sold. And there's the rub. This is long-term money, folks. If you want to get out of a HF, you will have to read carefully what the Offering Memorandum says: some will allow you to get out quarterly, some annually, some only when all the assets are sold sometime in the future.
And then there's the cost. Most fund managers are compensated on a quarterly management fee anywhere north of 1%. When they hit a target return after fees and expenses, they are allowed to take a performance fee usually around 20% of the gains. When you consider all those fees, plus the internal fees of trading and execution, plus administrative, legal, and accounting fees, you may be better off in a mutual fund.
On the whole, the unregulated arena of the HFs is a breeding ground for white-collar crime. The invisibility and lack of accountability allows for money laundering on a scale most of us cannot fathom. On the other hand, many small investors have found the returns on well-managed, legitimate HFs to have been the difference between a good return and a spectacular return, costs not withstanding. Know the breed.