Hedge funds are one of those murky terms that have a way of conjuring up all manner of strange significance. The playground of Ponzi schemers and jet-setters at one extreme to legitimate investments for the rest of us at the other, we’re in awe of the money they make and a bit confused as to how they do it. The Style section of the New York Times seems replete with photos of the rich and infamous “hedgies” and Greenwich, Connecticut, where many of them are sited, is the new Wall Street, with McMansions aplenty to prove it.
Just what are they, anyway? In short, hedge funds are nothing more than an investment partnership that caters to those who can afford to lose their entire investment, typically those having a net worth north of $5,000,000 and/or investible assets close to that.
Why would anyone want to invest? Besides making good fodder for cocktail party conversation, hedge funds can play an important role in a portfolio. Generally uncorrelated to other asset classes, they can provide a safety net when other things are blowing up. Recall that under normal conditions, various asset classes behave differently from one another, which is a good thing. After all, if equities are falling, you hope to have other things in your portfolio (like bonds, and better yet, cash) that are not. In theory, hedge funds are supposed to play a similar role by providing a “floor” to protect your portfolio.
Another reason to invest is that hedge funds have the opportunity to provide much higher returns than other asset classes. We’ve all heard about the enormous returns that hedge funds can and have delivered in times past. But they also can carry the potential for much more risk. The common method of measuring risk is through volatility, best exemplified through standard deviation. Remember the bell curve from statistics? Sixty-seven percent of the variation of returns falls within the bell. Hedge funds as an asset class deliver returns that frequently fall outside the bell curve, meaning they can have more risk associated with the returns they deliver.
Hedge funds also come with quirks like liquidity constraints and “lock-ups”. A lock-up means just that: you cannot withdraw any of your money for a particular period of time, generally a year from the date of your investment. After that, you must notify the fund, in writing, up to six months ahead of when you want to withdraw your money. Lock-ups are a good thing, as they give the manager time to sell securities to free up cash without being pressured to do so in a market that may not be advantageous. In reality, however, if the market is in free fall, and you need your cash to pay private school tuition, tough luck.
And then there is the matter of fees. High fees. Managers frequently charge on a basis of “2 and 20”, meaning a management fee of 2% on your invested capital plus an incentive fee of 20% of the profits. For example, suppose you put $1,000,000 into the pool, the manager extracts $20,000 upfront to manage the fund. Then, suppose the fund earns 10%, or $100,000. Not bad. However, the manager takes 20% of your $100,000, leaving you with $80,000. So, your $80,000 return that year actually cost you $40,000. Not bad for the manager, but to be fair, he has assumed the risk of launching and financing the investment, and his reputation and much of his own personal net worth is on the line. So, perhaps he’s earned his fat fee.
But, fair works in strange ways. Let’s now assume the manager loses 5% of your investment. He now must make up that 5% loss before he is eligible to charge the incentive fee. This is known as the “high water mark” which may make the high fee on the upside seem a little more palatable.
The biggest risk component of a hedge fund, however, is the use of leverage, or borrowed money. In a simple example, if you invest $1,000,000 and it earns 10%, you have $1,100,000 to show for it (before the manager takes his cut). If, however, you invest $1,000,000 and an additional $300,000 that the manager has borrowed, and the investment earns the same 10% return, you now have $1,130,000, or an additional $30,000 in return. That’s the upside of leverage. But, it can go against you just as readily. For example, if your $1,000,000 investment goes south, you can lose the entire $1,000,000. If, however, the manager has borrowed an additional $300,000, and the investment fizzles, the manager has lost not only your original $1,000,000, but must pony up the borrowed piece as well. Many hedge funds can’t do that, particularly in difficult markets that caused the loss in the first place. Investors stampede to get their money out, and managers can’t meet the demand. They have no choice but to liquidate the fund in its entirety. So, leverage can be tricky: it certainly can enhance returns on the upside, but it can be a disaster on the downside. Beware.
Part 2 of Merry Sheil’s article on hedge funds, Hedge Funds: Navigating the Maze of Risk and Reward, will be published tomorrow. Part 3, Hedge Funds: How to Plant Your Money, will appear on the front page on Wednesday.
This article is for entertainment purposes only. It is not to be considered investment advice. Everyone’s financial situation is different and before investing in any hedge fund, it is important that you consult your tax and investment advisor to see if these types of investments are right for you.