Hedge Funds

We hear a lot about hedge funds these days. These lightly regulated private funds have proliferated rapidly over the past few years, growing to an estimated 8,000 funds controlling over $1 trillion in assets. Some hedge funds have had spectacular returns. It's hard not to get a little tachycardic hearing about Stevie Cohen's 40% annual returns at SAC Capital Advisors. But numbers like that should be viewed with some skepticism. What exactly are hedge funds? And do they belong in your portfolio?

Hedge funds encompass a wide range of investment strategies. Some funds make bets on macro trends in the global economy. For example, hedge fund icon George Soros was dubbed "the man who broke the Bank of England" after making $1.1 billion betting on the devaluation of the British Pound in 1992. Other hedge fund strategies involve distressed securities, special situations, fixed-income arbitrage, managed futures, and so on.

Despite the dizzying array of complex investment strategies, hedge funds do have some common characteristics that help distinguish them from conventional stock funds:

1. Flexibility to go long and short: Hedge funds can buy stocks ("go long") or sell borrowed shares they don't own ("go short"). Most conventional funds are restricted to going long only.

2. Leverage: Hedge funds can use borrowed capital, such as margin, to increase their buying power. With leverage, the effect of price changes in a fund's underlying securities is magnified, thereby amplifying both gains and losses.

3. Absolute returns vs. relative returns: Hedge funds are judged on their absolute returns over a given time period, whereas conventional funds are typically judged relative to a benchmark such as the S&P 500.

4. Performance-based compensation: Hedge fund managers generally receive a percentage of investment profits, in addition to a flat percentage of assets under management. Most conventional funds have lower fees and no performance-based compensation.

5. They eat their own cooking: Hedge fund managers typically invest their own money alongside other investors.

As you can see, hedge funds have some desirable characteristics. And many of them have low correlations with general equity indexes, making them excellent portfolio diversifiers. However, there are two major problems with hedge funds. First, they have exorbitant fees. The above-mentioned Mr. Cohen charges his clients a whopping 50% of investment profits. A more typical fee structure is 2% of assets under management plus 20% of profits.

The second problem is that there is tremendous variability in hedge fund performance and no reliable way to pick future winners. Hedge funds are primarily sold based on their past performance. Many of the published reports on hedge fund performance show excellent returns. However, hedge funds only provide performance information to database publishers if they wish to do so. Not surprisingly, the funds that elect to report their results tend to be the better performing funds. Furthermore, the databases only report on existing funds, ignoring the many unsuccessful funds that have gone defunct. When these biases are taken into consideration, overall hedge fund performance is decidedly mediocre. More importantly, the past performance of a hedge fund has been found to be no better than a coin-flip in predicting future returns.

With no reliable way to pick a winner, you incur a substantial risk of selecting a dismally performing fund. Some investors attempt to mitigate this risk by investing in a "fund-of-funds," which spreads your assets among several hedge funds. While this approach has theoretical merit, it adds yet another layer of fees to the already egregious compensation structure.

Hedge funds are primarily used by institutional investors and the very wealthy, and appropriately so. For now, I generally only recommend them for individuals with over $5 million in investable assets. However, a number of hedge fund products are being rolled out for the merely well-off. If we find that one of these products combines sound investment strategy with a reasonable fee structure, we may consider using it to further diversify client portfolios in the appropriate setting. I'll keep you posted. In the mean time, please feel free to contact me with questions or comments.

Jeffrey J. Brown, MD CFA
Shearwater Capital

January 2006

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