Market Features

Want to Try Hedge Funds? First, Get Rich

02/24/08 - 09:56 AM EST

How do the rich get richer? Here's one way: They invest in hedge funds.

You don't hear too much about hedge funds if you're not an "accredited" investor or "qualified purchaser" with millions in investment assets. But there certainly are a lot of investors who fall into that category and are willing to pay significant fees to get into a hedge fund.

According to industry source Barclay Group, hedge-fund assets have grown from $323 billion in 2000 to more than $1.8 trillion last year. And the number of hedge funds has leapt during the last seven years, from around 550 to more than 13,000.

Hedge funds use varying strategies in their efforts to outperform market benchmarks such as the S&P 500 stock index. Some take "short" positions to offset their ownership of stocks. Others use futures and options to hedge their outright stock purchases.

Most don't explain exactly how they intend to "beat" the market -- and they aren't required to divulge their strategies.

HFR (Hedge Fund Research, Inc.), which maintains a huge database of hedge fund performance, says $100,000 invested in their Global Hedge Fund Index in January 2000 would be worth $177,000 at year-end 2007 -- net of all fees. The same amount invested in the S&P 500 would have been worth only $114,000.

That performance is truly outstanding when you realize that hedge funds typically charge performance fees of 20% of the profits, plus an annual management expense of about 1.5%.

However, hedge funds are not required to report their results publicly. Thus, performance records of funds that lose money and quietly go out of business are probably not factored into the HFR index.

Choosing a Hedge Fund

Morningstar, the company that rates traditional mutual funds, has just launched proprietary performance ratings for thousands of hedge funds and 17 hedge-fund indexes it created. The categories are based not only on the funds' self-descriptions, says John Reckenthaler of Morningstar, but also on historical performance correlations.

Since hedge funds are reluctant to reveal their positions, if not their strategies, this is admittedly a difficult task. Reckenthaler suggests these Morningstar Hedge Fund ratings are a "starting screen" and not the only way to judge hedge funds.

Chicago money manager Kay Torshen, president of Torshen Capital Management, LLC, specializes in choosing hedge funds for her clients, who range from wealthy individuals to endowments and pension funds.

She warns: "Hedge-fund managers are unusually sophisticated and intelligent, and can tell an attractive story. It's very important to evaluate the risk objectively and not get carried away by the glamour."

Hedge-Fund Warnings

Torshen notes that the current market volatility makes investing in a hedge fund even more complicated for four reasons:

Asset classes that used to move inversely to each other are becoming more correlated. In other words, domestic stocks, international stocks, oil, gold and commodity futures have all been declining in sync.

Hedge funds that post losses have the additional risk of losing portfolio managers. Those managers are compensated out of profits -- ordinarily a good incentive. But because the fund must make up its previous losses before paying out bonuses, its talent may quit to start fresh elsewhere.

Liquidity issues impair hedge-fund performance. Many hedge funds invest in unusual, early stage opportunities, whose business plans suffer in a credit crunch. Of course, hedge funds themselves are not a liquid investment. Many allow cash withdrawals only at year end, so they won't be forced to liquidate their investments because investors get scared.

Valuation of hedge-fund investments is difficult at any time, but particularly in a bear market. Selling an illiquid security to raise cash could cause its price to collapse. And the fund may have to estimate a valuation for an investment that is not publicly traded.

But Torshen also says that tough times, like the current market conditions, provide great opportunities, both for hedge fund managers and for investors. Well-performing funds that have been closed to new investors now are seeking additional capital to take advantage of distressed situations.

So how do you pick a hedge fund?

"Don't assume that the fund's strategy works, that it works in all market conditions -- or that they will have the discipline to execute it in all market conditions," Torshen says.

She suggests that hedge fund investors diversify -- spreading their capital between well-chosen funds with different market strategies -- or try a fund-of-funds. She reminds investors: "You can't be a market timer with a hedge fund; you can't just hire and fire managers based on a few months of performance."

Of course, stellar past returns are not guaranteed to be repeated in the future. And there's no guarantee that the best hedge funds will accept your money, even if you've been recommended to them by current investors.

Finally, you rarely hear the stories of hedge funds that collapse completely, losing almost all their assets -- unless they happen to make headlines like Long Term Capital Management or Amaranth.

There's a reason hedge funds are limited to sophisticated investors: They can afford to lose. And that's The Savage Truth.