Hedge Fund InvestorsShould we all be hedge fund investors? Over the last few months, the financial press has been covered with information about hedge funds. On the one hand, I can understand why, but much of the relevance remains a mystery to me. I'll try to explain why... It would be fair to say that hedge funds are at the 'high risk' end of the scale. For most of us, they are simply too risky to justify an investment. As an adviser, I'm not really too sure I could describe exactly what a client is investing in if he or she were to ask me for a definition of a hedge fund. I'd like to point out that this is not because of my ignorance either. I have actually been in the unusual position of having met four hedge fund managers or directors. This provides the opportunity to ask the odd question or two of the person who really knows the answer. If only it were that simple! A little background info might be in order. In investment, there are two types of return (no, not positive and negative), but alpha and beta. The return of the market is known as beta whilst the (hopeful) outperformance provided by the skills of the manager is alpha. These skills can be highly valuable. Outperformance of a market by a fund can produce extraordinary amounts of money. It should be rewarded. For fund managers who join the ranks of hedge fund managers, it just was not being rewarded enough. A normal collective investment fund, a mutual fund / unit trust / sicav (depending upon where you are reading this) will charge a fee to invest and an ongoing management fee. The management fee will usually be between 1% and 1.5% pa, whilst the initial fee might be 4% or 5% of the amount invested. I am obviously simplifying here as there are many possible permutations, but hopefully you get the idea. A hedge fund charges a little more. Many have an upfront fee, some as high as 7% of the amount invested, but more usually in the region of 5%. They also have an annual management fee of between 1% and 2% pa. However, they also have a performance fee which can be up to 25% of any outperformance!! From the funds I have seen, 20% is more normal, but that still is not really very normal. In short, there is a winner in the hedge fund game, and it is the fund managers, directors and promoters. A very pertinent topic would be to assess whether or not they are worth the money. Quite clearly that depends upon performance. Yet, many hedge funds have early exit penalties which mean that you, the investor, are going to find out if they offer value whether you like it or not. In fairness, many funds that aim at the mass market have similar early exit charges too, so this is not unusual. It is however, in my opinion, another reason why hedge funds are not very suitable for the general public. There is no monthly savings plan either. If you want to invest, get out your cheque book. Minimum investments vary from fund to fund, but anywhere between $5,000 and $25,000 will be a normal minimum. Bearing in mind that these are, as I said earlier, high risk, the investor should have a range of other investments in his or her portfolio. And since the proportion of a portfolio that should be allocated to high risk investments like these is small, a private investor should probably have somewhere between $250,000 and $750,000 already allocated. As you might be guessing, that narrows the market just a little. I for one, have not yet (to my knowledge) met anyone who is an ideal private hedge fund investor. It isn't just about wealth, the individual needs to be comfortable with the potential risks too. Yet despite this, I have met several people who are actual hedge fund investors. Go figure. Hegde funds are normally difficult to monitor and regulate. Did I say difficult? Apologies. I meant impossible!! The directors will likely be registered individuals in the UK or US, whilst the banking will be carried out by a major bank in some tiny far away island. The custodial services will also be operated by another big name bank in a different tiny island. The manager will be working in yet another tax free paradise (Bermuda is a favourite) and investing on global markets. This sounds great and highly logical. The fund pays virtually zero taxes, the fund manager probably pays very low personal taxes and is free to invest in any market that attracts at the time. How wonderful! But for the average investor, figuring out what they do with the money is still clouded in mystery. Rather than following a market and chasing relative returns (the return is relative to market performance), they can invest anywhere going long or short (backing prices to rise or fall) or make an arbitrage trade and so chase an absolute return. This is a big, big selling point. 'We can make money no matter how the markets move', is very compelling no matter who you are. There are other issues that need to be looked at about hedge funds too. Additional market volatility, suitability as a hedge for other investment funds and the types of leverage they use are great starting points. * This article was first published in the November 2006 edition of the newsletter *
Hedge Fund
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