This Day On The Street
Continue to site right-arrow
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
Cramer's Action Alerts PLUS - See his portfolio and get alerts BEFORE every trade. Learn more NOW!

Want to Try Hedge Funds? First, Get Rich

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.

BankingMyWay

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.

    RealMoney Barometer Poll
    1 What would best describe your stance heading into the coming week of trading?
    Bullish
    Bearish
    Neutral
    2 Which of these sectors do you think is set to move up in the coming week?
    3 Which of these sectors do you think is set to move down in the coming week?


    View the results without voting

    Terry Savage is an expert on personal finance and also appears as a commentator on national television on issues related to investing and the financial markets. Savage's personal finance column in the Chicago Sun-Times is nationally syndicated. Savage was the first woman trader on the Chicago Board Options Exchange and is a registered investment adviser for stocks and futures.

    Check Out Our Best Services for Investors

    Action Alerts PLUS

    Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

    Product Features:
    • $2.5+ million portfolio
    • Large-cap and dividend focus
    • Intraday trade alerts from Cramer
    Quant Ratings

    Access the tool that DOMINATES the Russell 2000 and the S&P 500.

    Product Features:
    • Buy, hold, or sell recommendations for over 4,300 stocks
    • Unlimited research reports on your favorite stocks
    • A custom stock screener
    Stocks Under $10

    David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

    Product Features:
    • Model portfolio
    • Stocks trading below $10
    • Intraday trade alerts
    14-Days Free
    Try it NOW
    Only $9.95
    Try it NOW
    14-Days Free
    Try it NOW

    Check Out Our Best Services for Investors

    Dividend Stock Advisor

    David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

    Product Features:
    • Diversified model portfolio of dividend stocks
    • Updates with exact steps to take - BUY, HOLD, SELL
    Trifecta Stocks

    Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

    Product Features:
    • Model Portfolio
    • Intra Day Trade alerts
    • Access to Quant Ratings
    Options Profits

    Our options trading pros provide over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

    Product Features:
    • Actionable options commentary and news
    • Real-time trading community
    Try it NOW
    Try it NOW
    Try it NOW
    To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
    Submit an article to us!
    SYM TRADE IT LAST %CHG
    AAPL $130.42 1.26%
    FB $80.41 1.07%
    GOOG $555.48 2.13%
    TSLA $207.19 1.68%
    YHOO $44.45 0.04%

    Markets

    DOW 18,214.42 -10.15 -0.06%
    S&P 500 2,110.74 -3.12 -0.15%
    NASDAQ 4,987.89 +20.7530 0.42%

    Partners Compare Online Brokers

    Free Reports

    Free Newsletters from TheStreet

    My Subscriptions:

    After the Bell

    Before the Bell

    Booyah! Newsletter

    Midday Bell

    TheStreet Top 10 Stories

    Winners & Losers

    Register for Newsletters
    Top Rated Stocks Top Rated Funds Top Rated ETFs