Objective information about financial planning, investments, and retirement plans

What is a Hedge Fund?

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The term hedge fund is used often in the financial press.  I suspect, however, that many investors do not really know what a hedge fund is.

What is a Hedge Fund?

 

 

 

 

Investopedia defines a hedge fund as follows:

“An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).” 

Here are a few basics about hedge funds to help you understand them.  Note this is certainly not meant to be an in-depth tutorial but rather is meant to provide an introduction to hedge funds.

Who can invest in hedge funds? 

In order to invest in a hedge fund you must be an accredited investor.  The current definition of an accredited investor is someone with a net worth of $1 million (excluding the equity in their home) and at least $200,000 in income ($300,000 with a spouse) over the past two years.  Many hedge fund investors are institutional investors such as foundations, endowments and pension plans.  About 65 percent of the capital invested in hedge funds comes from institutional investors.

What is the minimum investment? 

The minimum required to invest is often $1 million or more though some smaller hedge funds and funds of funds may have lower minimums.  New companies like Sliced Investing are seeking to change these high minimums by allowing investors to invest as little as $20,000.

Do I have access to my money? 

Unlike mutual funds, ETFs, closed-end funds and individual stocks hedge funds typically do not offer daily access to your money.

Some hedge funds allow investors to subscribe (invest) or redeem their money monthly, for others this might be quarterly or based upon some other time period.  Most hedge funds will require advanced notice for redemptions which might be as long as 180 days.  This allows the fund managers time to raise sufficient cash and allows for an orderly sale of fund investments especially if the redemption is a significant amount.

Some hedge funds also require a lock-up which means that there are no redemptions allowed during this initial period.  A typical lock-up period is one year, though some are as long as two years.  In some cases the lock-up period is “soft” meaning that redemption can be made but there will often be a penalty ranging from 2 percent to as high as 10 percent. 

Some hedge funds may also have the ability to enforce “gates” on redemptions which means they can decide to process only a portion of the redemptions requested.  This provision came into focus during the 2008-2009 market downturn as hedge fund redemptions requests swelled as many investors sought to raise cash.

What types of fees are charged? 

The fees charged by hedge funds vary widely.

Many hedge funds charge a management fee of 2 percent or more.

There might also be incentive fees of 10 to 20 percent of the fund’s profits or more.  This rewards the fund manager for superior performance.  The flip side of this is that the manager generally only collects an incentive fee if the fund’s performance exceeds its former highs, known as a high water mark.

If a fund loses 5 percent in a given year, no incentive fees will be paid to the manager the following year until the 5 percent loss is made up.

The term two and 20 is a common one in the hedge fund world meaning that the fund would charge a 2 percent management fee and a 20 percent incentive fee.  This may seem pricey but if the performance is stellar then investors won’t mind paying it. 

What types of investment strategies are available? 

There is a vast range of investment strategies across the hedge fund landscape.  These might include long-short, global macro, market neutral, convertible arbitrage, distressed securities and many others.  Additionally there are a number of fund of funds offered which means that the fund offers a collection of strategies and fund managers under one umbrella.   

What should I consider before investing in a hedge fund?

From reading the above you might ask yourself why would I invest in hedge funds?  Let’s remember that hedge funds are considered alternative investments.  Ideally they will have a relatively low correlation to the traditional long-only equity and fixed income investments in your portfolio.  At their best well-managed hedge funds can add balance and reduce the overall risk of your portfolio, in some cases the strategies are designed to provide absolute returns across all investing environments.

Before investing in a hedge fund or any alternative investment make sure you have considered and fully understand the following:

  • The fund’s investment strategy.
  • How this investment strategy fits with your overall portfolio and investing strategy.
  • What the fund “brings to the table” that you can’t get with more traditional long-only stock and bond investments.
  • Who is managing the fund and their history and investment track record.
  • The required minimum investment.
  • Any redemption restrictions and/or lock-up periods.  Make sure that you won’t need to tap this money during this time period. 

The Bottom Line 

Like any investment option you might consider it is important to understand the pros and cons of hedge funds in general and any specific fund or strategy that you might be considering for your portfolio.

Disclosure: This blog post was written for Sliced Investing pursuant to a paid content arrangement I have with the company’s representatives as part of an effort to raise awareness about alternative investment options. All views expressed are entirely my own, and were not influenced or directed by Sliced Investing.

Photo courtesy of Wikipedia

Are Alternative Investments the Right Alternative for You?

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Alternative investments are all the rage these days.  Mutual fund companies are falling all over themselves to sell financial advisors and their clients on “liquid alts” or hedge fund-like strategies with the daily liquidity offered in a mutual fund wrapper.  Hedge funds were allowed to advertise due to a change in the rules last year.  The financial press is filled with articles about alternatives and the fund companies are offering numerous webinars and conferences covering them.

Are alternative investment strategies right for your portfolio?  I have no idea but here are some questions to ask as well as some information for you to consider.

What is an alternative investment strategy?

Alternatives are basically investment vehicles that aren’t purely stocks, bonds, or cash. The purpose of alternatives is generally to diversify an investment portfolio.  Ideally these strategies will have a low correlation to other investment vehicles in your portfolio.  Examples of alternative strategies include:

  • Hedge funds
  • Unconstrained fixed income
  • Macro strategy funds
  • Commodities and managed futures
  • Real estate
  • Precious metals
  • Long/short equity
  • Convertible arbitrage
  • Private equity
  • Vulture funds
  • Venture funds
  • Merger arbitrage 

As mentioned above, these strategies are available in the more traditional hedge fund format, as mutual funds, ETFs, and as fund of funds in each of these formats.

Consider this before investing in alternatives 

Before buying an alternative fund or product here are a few questions to consider:

  • Do you understand the underlying investment strategy?
  • What benefit will this investment provide to your overall portfolio?  Reduced volatility?  Low correlation to other holdings?
  • What are the expenses? Are they justified given the expected benefit of investing in this alterative fund?
  • Are there any restrictions on redeeming your investment? Typically (but not always) with a mutual fund or ETF the answer is no, hedge funds may have a lockup period or other restrictions.
  • Have this fund’s performance been tested in real market conditions or just back-tested on a computer?
  • Who’s managing the fund?  What is their background and track record? 

I am actually a fan of alternatives and have used several mutual funds of this type for a number of years.

Remember though, large endowments like those of the Ivy League schools use alternative investments extensively and successfully.  Unlike you they have access to the expertise needed to perform proper due diligence. Does the financial advisor recommending these funds to you really understand them? Be sure that you do before investing in any alternative investment product.

Please feel free to contact me with your questions. 

Check out an online service like Personal Capital  to manage all of your accounts all in one place.  Please check out our Resources page for more tools and services that you might find useful.

Prognosticators or Product Sellers?

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PIMco’s Bill Gross is arguably the best bond manager around and a really smart guy.  He and several of his PIMco colleagues are also master salesmen, just witness the number of appearances on CNBC and how often they are quoted in the financial press.  In the interest of full disclosure I have a fair amount of client assets invested with PIMco.

CNBC.com - 1996

In his August investment outlook letter, Gross proclaimed “… the cult of equity is dying.”  As we’ve come to expect, Gross lays out a very logical case to support his argument and he also says that the bond returns that we’ve seen over the past 30 years are unlikely to be replicated into the future as well.

At the end of the day this is a stroke of genius on many levels.  First it’s controversial and gets people writing and talking about Gross and PIMco.   Second, even with a new push into equities, PIMco is a bond shop.  I can’t help but think that anytime Gross talks down equities there is some motive, conscious or otherwise, to push PIMco’s fixed income products.

Josh Brown in his excellent blog The Reformed Broker recently wrote a post calling out Morgan Creek CEO and CIO Mark Yusko for predicting flat returns for equities over the next 9-10 years and conveniently suggesting alternative investments as the only way for financial advisors to achieve the types of returns their clients expect over this time horizon.

Morgan Creek is in the alternative investments business, and while I’m sure Mr. Yusko is a very bright guy, let’s face it this is just another thinly veiled sales pitch, aimed at financial advisors, for what his firm is selling.

The list goes on and on.  Except during the duration of the Olympics, I generally have CNBC on in the background during the business day.  Many of the guests function in the same fashion.  “Equities are the place to be” might be the mantra of a growth stock mutual fund manager.  The manager of a commodities fund might be predicting inflation into the future and touting commodities as a way to hedge against it.

Look I’m not saying any of these folks are bad people and don’t know what they are doing.  Whether you are a money manager or a financial advisor, you have to engage in sales and marketing in order to attract clients.  Financial advice is a business like any other in that respect.

As a financial advisor whose clients count on me to recommend financial strategies and the products to implement those strategies, I’ve learned to be an intent, but detached listener of pitches.  I attend several conferences throughout the year and listen in on any number of webinars and conference calls on a regular basis.  Many of these are sponsored and presented by financial services providers.   Generally there is much good information presented, but one always has to listen with a critical ear.

As always, please feel free to contact me with any financial planning questions or concerns you may have.

Photo credit:  Wikipedia

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