The first step in being a successful investor in hedge funds or other types of investments is getting in the driver’s seat and learning everything you can about timely opportunities and how they mesh with your objec- tives. Cruising along, pursuing the same investment philosophy that you have used for years, is certainly an option, and if you are achieving the returns you want, that is a wise road to follow. However, if you are like most investors, it is likely your investment process could use a boost. Exploring the addition of hedge funds to your portfolio is a good use of your time and effort, and you are smart to learn everything you can about this asset class.
What exactly is a hedge fund? For years, hedge funds have been the subject of cocktail party talk and an oft-discussed subject for news arti- cles and business shows. Unfortunately, most investors do not really understand hedge funds or how they differ from traditional stock and bond investments. One of the common comments is that hedge funds are risky, a belief fueled by misconceptions and a lack of understanding in the area. For instance, the very meaning of “hedge” implies reducing risk. Hedge funds continue to spark the curiosity of investors, yet with that curiosity comes a need to better understand the industry and its respec- tive strategies. Before thinking about whether to invest in hedge funds, investors need a clear understanding of what a hedge fund is, what it is not, and how it works. (See Table 1.1.)
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Basically, hedge funds are considered to be a type of alternative investment, along with venture capital and private equity funds, real estate, and commodities. (See Figure 1.1.) The term “hedge fund” is derived from the practice of investment managers who took long posi- tions in various securities and then hedged against the risk of a general market decline by taking short positions in other securities. In practice, the term has a much broader usage, generally referring to private invest- ment vehicles that, by availing themselves of certain exemptions allowed in current securities laws, may utilize a wide range of investment strate- gies and instruments.
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TABLE 1.1 Overall Objectives of Alternative Investments
• Preservation of captial
• Wealth accumulation/growth
• Management of risk and volatility
• Enhanced returns
• Low correlation/diversification
• Access to strategies unavailable to traditional managers
• Hedge funds
• Private equity
• Venture capital
• Real estate
• Natural resources
• Stocks
• Bonds
• Cash equivalents Investment Universe
Investment Universe
Alternative Investments
Alternative Investments Traditional InvestmentsTraditional Investments Absolute return investment strategies and funds
are commonly known as hedge funds.
FIGURE 1.1 Alternative Investment Strategies.
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The Hedge Fund Alternative 3
In the simplest, formal terms, hedge funds are little more than commingled pools of capital structured as limited partnerships, lim- ited liability corporations, or offshore investment companies, offered exclusively via private placements to a relatively limited number of accredited investors who meet certain predetermined qualifications set forth in federal securities laws. These laws provide strict criteria for those eligible to invest in hedge funds. Hedge funds require that at least 65 of their 99 allowed investors be accredited, as defined as an individ- ual or couple with a net worth of at least $1 million, or an individual who had an annual income in the previous two years of at least
$200,000 ($300,000 for a couple). In reality, a potential hedge fund investor needs more than that to be fully diversified and qualify to meet the fund’s minimum investment requirements. Minimum requirements range from $250,000 to $10 million, and the most common ones range between $500,000 and $1 million. New regulations allow for up to 499 investors per hedge fund as long as all the investors are qualified pur- chasers, which are defined as individuals with at least a $5 million liq- uid net worth. (See Table 1.2.)
Securities laws also regulate how hedge funds may obtain assets.
Hedge funds are not allowed to engage in any form of public solicita- tion of funds but can acquire funds only through means of completely private introductions or existing relationships. The thinking behind
TABLE 1.2 Traditional versus Hedge Funds
Traditional Hedge Funds
Performance objectives Relative returns Absolute returns Investment vehicles Stocks, bonds, cash All asset classes/vehicles
Investment strategies Limited Wide range
Regulation structure Regulated Largely unregulated Performance drivers Asset class and market Fund manager skill
correlation
Fees Management fee only, Management fee plus
rarely performance performance incentive fee incentive
Liquidity Unrestricted, often daily Restricted c01_hedges.qxd 8/30/04 11:58 AM Page 3
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these regulations is that such investors are sophisticated enough to understand the kinds of investment techniques a hedge fund manager may employ and thus appreciate and withstand the kinds of risks being taken. However, these two components of the regulatory structure help to foster an image of the industry as exclusive, elite, and secretive. The Securities and Exchange Commission (SEC) currently is reviewing the subject of hedge fund marketing as part of its ongoing review of hedge funds; investors may see changes to these rules in the coming years.
Another significant defining attribute of hedge funds deals with the fees charged. In contrast to traditional long-only investment managers, most hedge fund managers charge their clients an incentive fee in addi- tion to a standard management fee. The most common fee structure includes an annual management fee of 1 percent of assets under manage- ment and 20 percent of the net annual return. Much of the continued strong growth of the hedge fund industry stems from this factor alone.
Because of the potential to earn significantly more money as a hedge fund manager than as an employee of a large financial institution, the motiva- tion to start and manage a hedge fund is compelling. Indeed, large, suc- cessful hedge fund managers can earn multimillion-dollar salaries, and clients typically do not mind paying high performance fees when the manager is achieving strong, justifiable results.
The investment industry has come to use the term “alpha” (in dis- tinction to “beta,” referring to the normal return of any given market or security) to refer to both the ability of a manager to outperform a benchmark and to the degree of outperformance itself.
Thus, it is helpful to think of a hedge fund as an investment vehicle where the preponderance of the return comes from the skill of the trader rather than the return of the markets. Although not without disadvan- tages, this arrangement is generally accepted as an essential dynamic of hedge fund performance and worth the price for superior investment returns.