Getting Into Hedge Funds

Portfolio Hedging

Getting in the Money

Hedge funds are opening their doors to a wider investor class. But before you fall hard for those triple digit returns, here’s the basics of using hedge funds to diversify your portfolio and a look at what brings those financial, and emotional, highs and lows.

It’s hard to ignore the news of those triple-digit run-ups. While the Standard & Poor’s 500 index eeked out just a four percent gain last year, certain highflying hedge funds were seemingly defying market swoons. Balestra Capital Partners LP was up 199 percent, HFH ShortPLUS fund, LP rose 191 percent and several other top performing funds returned over 100 percent.

A decade ago hedge funds, which don’t face the same Securities and Exchange Commission regulations as mutual funds, were purely for the ultra-wealthy and large institutional investors like college endowments. But since 1998, hedge funds’ assets under management have ballooned from $240 million to an estimated $2 trillion. The approximately 7,500 hedge funds out there have thrown open their doors to a wider class of investors, and now many financial advisors recommend that their clients allocate 10 to 20 percent of their portfolios to hedge funds. So when stocks are slumping, real estate is in the doldrums and bond yields are headed lower, one solution is to diversify. Hedge funds could be the answer, provided you learn how to research funds and understand their unique investment strategies in order to break down the best way to get into this investment product.

You can start researching on your own, if you have the means

Researching hedge funds means turning to specialized resources. Just a few years ago, hedge fund performance was a closely held secret: funds didn’t publish their performance to the general public, and the only clue to their returns in the wider investment world was when a fund tanked or sought out a bail-out, and the financial media descended. Now hedge fund performance is more widely available on both Morningstar and Lipper HedgeWorld. However, access to the most detailed information requires signing up for subscription services at those sites. And there’s another catch, the data is only available to those who qualify as an accredited investor in the eyes of the Securities and Exchange Commission, so you’ll need an average yearly income of at least $200,000 over the last two years, or assets totaling a minimum of $1 million.

For those who do qualify, there is a wealth of information online. Morningstar’s Hedge Fund service, for instance, tracks some 6,000 funds and produces reports that break out a fund’s annual performance, trailing performance over time and the number of positive and negative performing months over the last one-, three- and five-year periods as well as basics like management fees and minimum investment requirements. Lipper Hedgeworld tracks some 4,200 hedge funds in its database, and accredited investors can search for funds by investment focus or financial instruments, like currency hedging, that fund managers use in investing. Lipper’s premium-level membership goes for $895 a year, and includes monthly performance on some 600 funds-of-funds, hedge funds with portfolios made up of other hedge funds.

The less risky way to get into hedge funds

Unique investment strategies can pay off big. Or not. Hedge funds can make large, concentrated bets that an asset class or a specific investment will increase in value, and they can use leveraged, or borrowed, funds to magnify the investment results. Hedge funds may often make stakes in investments that are less liquid like real estate and private equity or use investment strategies that the typical mutual fund manager isn’t likely to touch.

Hedge funds can also engage in short selling, a technique for selling someone else’s securities when you think the price will fall so you can buy it back later. Make the right bet, the payoff can be enormous. Choose wrong, and the results can be disastrous. For instance, Lahde Capital correctly anticipated the sub-prime mortgage debacle and returned over 1,000 percent through mid-October 2007, while the Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage (Overseas) Fund went belly-up (perhaps an early clue that Bear Stearns was in for bigger trouble) in 2007 after suffering heavy losses from investments in sub-prime debt.

But you don’t need to invest in aggressive funds if you already own other high-volatility investments like technology stocks and emerging markets mutual funds. In most cases it makes sense to look for lower-risk hedge funds. One solution is investing in absolute-return funds, designed to generate steady returns with low volatility and low correlations to the markets. These strategies can include relative-value funds, which try to exploit price discrepancies between securities, special-situations funds that seek profits in mergers and other corporate events, or trading funds, which take both long and short positions in a wide range of assets and markets. A word on average returns. They don’t mean much. You need to consider each fund’s individual returns and its performance relative to similar funds. And don’t overlook the risk a fund took to produce its returns. If two funds have comparable results, go for the one with steadier returns over time if you are seeking less volatility.

Invest directly or through funds-of-funds

With a direct investment, you research and invest in the hedge fund that meets your criteria. Each fund sets its own minimum investment, which can be as high as $5 million, though most fund’s minimum stakes fall between $500,000 and $1 million. Another option are funds-of-funds, which maintain lower minimum investments, typically in the $100,000 to $250,000 range. Each fund pools money from investors and then invests in multiple hedge funds, similar to the way mutual funds buy stocks and bonds. There is a catch though, such funds-of-funds only disclose their current holdings to investors who are considering investing, making casual research into a fund’s holdings challenging. Funds-of-funds do, however, provide greater diversification to investors and the fund-of-funds manager takes on the role of researching the managers and investments among each individual hedge fund in the portfolio. You’ll pay a management fee to the fund-of-funds manager in the range of one percent annually, and also give up as much as 10 percent of profits. Performance-wise this can also protect you from some of the wider market swings. While equity hedge funds were down 5.8 percent in the first quarter of 2008, funds of funds performed slightly better, down 3.9 percent.

Why hedge fund managers keep getting richer

Can you invest? While hedge funds have grown by attracting a wider group of investors, you still need to meet certain criteria in order to invest. The Securities and Exchange Commission (SEC) determines who qualifies for the “accredited investor” status required to invest in hedge funds, and some funds impose even higher standards. The fund manager will ask you to document your financial status. If you don’t meet these minimums, consider a fund-of-funds. The SEC requires a net worth of at least $2.5 million, not including your personal residence and cars, and annual earnings of at least $200,000 (or $300,000 with spouse) during the past two years with a reasonable expectation of earning at least that amount in the future. Even if you qualify, don’t be surprised if some funds don’t want your money. The best-performing funds often stop accepting new investors after they reach a certain size so the fund doesn’t get too large and cumbersome. If that happens, check into whether the manager has another fund with a similar strategy.

You’ll also pay heavily for your investment. After all, there’s a reason those hedge fund managers continue to pick up multi-million dollar beach homes in the Hamptons and on Nantucket, even in years where the rest of us saw our investment portfolios sink. In addition to management fees, which are typically in the range of two percent of assets, versus an average of 1.25 for the typical mutual fund, hedge fund managers also take a 20 percent cut of any profits. Even if a $500 million fund is flat, management still reaps a $10 million pay day.

Hedge fund personalities

Five high flying hedge fund managers and why they have landed in the news
Paul Tudor Jones
Newsworthy moment: Mr. Jones, who raked in $750 million in 2006, launched the Robin Hood Foundation, a non-profit targeting youth poverty in New York, which was hailed by Fortune Magazine as “one of the most innovative and influential philanthropic organizations of our time.”.
Bruce Kovner
Newsworthy moment: Mr. Kovner, who runs Caxton Associates, spent $70 million to purchase 12 acres of oceanfront property in Santa Barbara.
Steven A. Cohen
Newsworthy moment: An avid art collector, Mr. Cohen, director of SAC Capital Partners, had arranged to purchase Picasso’s Le Reve from casino mogul Steve Wynn for a record $139 million. Mr. Cohen promptly cancelled the transaction after Mr. Wynn accidentally put his elbow through the canvas while showing the painting to friends. In 2006 Cohen bought de Kooning’s Woman III from David Geffen for $137.5 million.
Edward “Eddie” Lampert
Newsworthy moment: Fortune Magazine called the man who rescued K-mart, “the best investor of his generation.” Lampert spent $20 million dollars to buy his Greenwich, Conn. property, only to tear the house down completely to rebuild.
Jeffrey Epstein
Newsworthy moment: Mr. Epstein made headlines when he purchased the single largest residence in Manhattan, a 50,000 square foot townhouse. He would make headlines again, when he was indicted for paying under-aged girls $200 for erotic massages at his Palm Beach mansion.
Due diligence questions
1.How much experience do you have managing a fund like this one and what were the results?
2.How have you performed compared to funds with similar strategies?
3.How much leverage do you use and do you have reserves to cover losses?
4.Have there been any civil or criminal charges, or lawsuits brought against you or your associates?
5.What are your redemption and communications policies?
6.What fees do you charge?
7.How can I redeem my investment?
8.How much of your personal wealth have you invested in this fund?

The big players

JP Morgan Asset Management, now the world’s largest hedge fund manager, earning the No. 1 spot on Alpha magazine’s just-released “2007 Hedge Fund 100” list.

Goldman Sachs Asset Management hedge fund is the second largest in the world, valued at $32.5 billion.

Bridgewater Associates is a global investment manager that manages approximately $160 billion in assets. Approximately $32 billion is invested in the firm’s hedge fund strategy, Pure Alpha, making it one of the largest hedge funds in the world.

D.E. Shaw Group, is a New York-based hedge fund and technology development firm whose activities center on various aspects of the intersection between technology and finance. It was founded by David E. Shaw, who was formerly a faculty member in the computer science department at Columbia University.

Farallon Capital investments are primarily those in which a known or expected event (a merger, restructuring, recapitalization or other major change) will cause an appreciation in the value of the particular investment.

Favorite Hedge Fund research websites

Securities Exchange Commission
The SEC website provides some basic, but reliable, information on hedge funds, including information for investors who feel like they may have been fleeced by one.

FT Alphaville
Invaluable insight into global markets, up to the minute news (the site is updated multiple times over the course of the day) and chats with key players, make this site a must visit.

The New York Times’ DealBook
The blog of the New York Times’ Business section, edited by Andrew Ross Sorkin, covers hedge funds, with timely and spot-on analysis.

For a true insider’s perspective, turn to Fintag. A bit snarkier, and with less of an emphasis on the numbers than some blogs, it more than makes up for it with incisive analysis and, of course, the stick-figure illustrations.

Morningstar is the place to go for info on all manner of securities. The Chicago based website provides valuable information on more than 125,000 investment offerings.