|A hedge fund run by my granny would
have beaten the markets in 2000-2003. A healthy scepticism is
in order as these opaque vehicles become more widely marketed.
What are they?
A US investment manager named A W Jones is reputed to have been
the first (in 1949) to set up an investment partnership with an
investment strategy of hedging out the market risk (see shorting)
by selling stocks as well as buying them. So he called it a hedge
But you should forget about the word 'hedge'. Now,
any enterprise that tries to profit from buying and selling financial
instruments and investments (including derivatives) can be called
a hedge fund. The defining feature of hedge funds is that they are
unregulated. This arose, historically, from the fact that shorting
was not allowed in a regulated fund sold to the general public.
The name may have stuck because so many of the trading
strategies involve buying one thing and selling another. And perhaps
a teensy-weensy bit because the word 'hedge' has a more comfortable
feel than 'unregulated' or 'speculative' or even 'arbitrage'.
Now (2008) there is some $1.3trillion invested in
hedge funds, earning perhaps $2.5billion in fees annually for their
Types of fund
Some funds may operate in a way that is almost indistinguishable
from unit trusts - just buying and selling stocks. Others may engage
in the most complex trading strategies, using sophisticated derivatives
to slice and dice their risk into the shape that they want, and
then maybe using leverage
to magnify the very small gains into much bigger ones.
A non-exhaustive list of hedge fund trading strategies
on stock price differences (like the GM/Ford example in shorting)
on the price difference between a convertible security and the
on the outcome of takeovers
on recovery stocks
on the occurrence of specific events
unit trusts (therefore never the only strategy in a hedge fund)
positions (betting on stocks falling)
on computer models
on movements in global economies, as reflected in interest and
exchange rates and other macroeconomic derivatives
in other hedge funds
It is usual, though not invariable, for the managers
to have their own money in the fund. This is good. but don't forget
they take their (risk-free) management fees first.
In a nutshell
If you invest in a hedge fund you are lending your capital to a
team that aims to make money for you (and themselves) by living
on their wits in the markets. It's a skill business, like currency
trading, oil prospecting or poker.
Do they work?
Who knows? The actual
running of any hedge fund is opaque. In an investment trust you
can periodically scrutinise the investments of the trust and hear
the excuses of management. In a hedge fund you'll hear what the
management wants to tell you.
Data on the long-run returns
of hedge funds is thin on the ground. To the extent that it is available
at all, it will be biased by the standard techniques available to
fund managers: selective
biases and pick
The data will be particularly
affected by the statistical bias of survivorship.
There are probaly now some 10,000 hedge funds worldwide. 10-20%
of them close every year (to be replaced by others). So the turnover
in this secretive and unregulated industry is high. Do you think
the funds with good records close?
Any other snags?
- Fees: You will be charged a fixed % (maybe
1%, maybe as much as 4%) and a performance fee (maybe 20% of the
profits). We have views on performance
- Opacity: Secrecy is both endemic and necessary.
If a trader spots a profitable market opportunity he cannot exploit
it if it is common knowledge.
- Risk: Even if your fund claims to be following
a low-risk trading strategy today, what about tomorrow? And how
do you know it's low risk (when performance fees encourage a "double-or-quits"
mentality)? And leverage
can turn a small risk into a big risk.
- Most of these funds are unregulated. They
need to be , because they use trading techniques proscribed for
more conventional funds, and because they demand secrecy. 'Unregulated'
does not mean 'crooked' or 'dodgy'. It just means what it says
- the funds are set up to operate outside the regulatory regime
designed to protect inexperienced savers.
- Tax. Can be tricky. Gains may be charged
as income and losses may not be offsettable. Take advice.
- Liquidity. You can buy, but can you always
- Valuation. Funds can invest in some pretty
obscure stuff. Who is to say what it is worth if there is no quoted
market for it? Could the manager be tempted to pump the valuations?
This is one of the ways that Enron covered its tracks.
- This is a people business, but your investment
is in the fund. What happens if the manager walks?
the managers do?
A few managers of private hedge funds (funds for small numbers of
extremely rich clients) have become famous. George Soros is perhaps
the best known. This has made them sexy. Sexiness, in investment
as in life, is the enemy of good judgement.
The hedge fund premise is that skilled management
can deliver exceptional returns - in good times as in bad. They
put your money where their mouth is by charging high fees, often
supposedly performance-related. These
are an illusion (performance
fees).The high transaction costs of active dealing add to this
Are they risky?
Some are, some aren't. But if they aren't, how
do you think they make any money? Risk
Hedge funds are particularly prone
to the trap of the hidden
rare event and the dangerous charms of leverage.
Read the cautionary tale of Long Term Capital Management (which
collapsed in 1998), most digestibly told by Roger Lowenstein in
his book "When Genius Failed". Worth it just for his description
of LTCM's trading methods: "picking up nickels in front of
a bulldozer". LTCM was run by a 'dream team' led by two Nobel
prizewinners. When it collapsed it had $5billion of equity supporting
$125billion of debt and $1,250billion of risk exposure to derivatives
not on its balance sheet.
Aren't they good for diversification?
Maybe. But the trouble with this argument is
that it can be applied to any tatty old business that responds to
economic drivers different from those of the market as a whole.
Why not invest in insolvency practitioners or pawnshops?
You sometimes read "hedge funds can make money
in both good markets and bad". This is true, but disingenuous.
The profitability of hedge funds depends, instead, on market volatility.
So you might say "equities can make money in periods of both
high and low volatility". Which would be just as true and just
Hedge funds are often described as a separate asset
class. Good diversification means you should have a piece of all
the major asset classes. Therefore you should should invest in hedge
Nice try! But there is no fixed rule for defining
asset classes. Why not currency trading or oil exploration as separate
asset classes? After all, hedge funds are only 5% of the value of
the businesses quoted on the world's stock markets. It is not actually
helpful to call hedge funds an asset class. Their common feature
is not what they do, but their ownership structure while doing it.
Just ask yourself: What economic service are they delivering? From
who do they make money - if they are winning, who is losing? Is
there a limit to the total size of the hedge fund cake (hedge fund
profit worldwide) or is the cake unlimited? If the cake is limited,
why do you think your position in the pecking order entitles you
to a slice of it? Does the law of dimishing returns operate (so
that each new dollar of hedge fund investment makes less money than
the previous dollar)?
If you understand the risks;
have read and understood the investment philosophy of the fund;
believe in the market judgement and technical skills of the managers;
and can logically justify their claim to make excess returns sufficient
to cover their charges and still leave something for you..........
the best of luck to you.
For anyone else, keep clear.
This is not a game for the amateur.
We hope you are not thinking of a Fund of Hedge Funds.
How on earth are the poor underlying funds going to generate enough
profit to pay the extra layer of costs - sometimes with another
performance fee thrown in? Understand Risk
Premiums, look at How
Much Return? and do the maths.