SAN FRANCISCO (MarketWatch) — Hedge funds don't beat around the bush.
These specialized portfolios are the darlings of the investment world, attracting top managers, institutions, pensions and wealthy individuals to their fold. The business oversaw less than $50 billion in 1990 and now controls more than $2.56 trillion, according to the eVestment/HFN Industry report. In that time, the definition of a hedge fund has broadened as managers have moved into new markets and developed new strategies.
What's more, the definition of a hedge-fund investor has also expanded to encompass regular folks with thousands of dollars, rather than millions, to spend. The progressive democratization of hedge funds opens ordinary investors to skilled managers.
Yet as the saying goes, be careful what you wish for: global market volatility has socked many hedge-fund investors, and relaxed hedge-fund rules also expose novices to risks they might not fully appreciate.
What to watch for:
Hedge funds share features that present both opportunity and risk. Portfolio managers typically take short positions in securities — bets on falling prices — as well as long positions that benefit from rising valuations. They also use borrowed cash — leverage — to magnify returns.
The idea is to hedge against market declines (hence the name) and produce consistently positive returns, irrespective of the direction of the overall market. That "absolute" return goal contrasts with traditional mutual funds, which declare victory if they simply outperform benchmarks such as the Standard & Poor's 500 Index.
The main allure of hedge funds is that, when done well, they contribute return that isn't closely tied to global stock and bond markets, providing diversity to an investor's portfolio.
"They add balance," said Chris Cordaro, chief investment officer at Regent Atlantic Capital LLC, a wealth-management firm that oversees more than $1.5 billion. "They can offer equity-like returns with bond-like volatility and little or no correlation with equity and bond markets."
While access to hedge funds is easier, the biggest and best managers are still primarily reserved for those with at least $1 million to commit. Those with less have a smaller selection that includes so-called funds of hedge funds, which allocate to a range of underlying managers, and mutual funds employing hedging tactics.
Man Group UK:EMG, for example, one of the world's largest hedge fund companies, offers the Man-Glenwood Lexington fund. This fund of hedge funds invests in a range of underlying managers. It's registered with the Securities and Exchange Commission, has an investment minimum of $25,000 and is sold via financial advisers using distributors such as Charles Schwab & Co.
Other firms have introduced similar retail funds. One that Cordaro likes is the Absolute Strategies Fund ASFIX, +0.71% , which invests in several underlying managers, including Aronson+Johnson+Ortiz, Metropolitan West Asset Management and SSI Investment Management. The Class-A shares ASFAX, +0.73% , have a minimum initial investment of $10,000. Cordaro also favors the Hatteras Alpha Hedged Strategies Fund ALPHX, -0.62% .
So-called hedged mutual funds are also gaining popularity. These funds that use some of the tools and strategies common to hedge funds, such as short selling and leverage. But they offer the benefits of mutual funds, such as lower minimum investments, daily liquidity and lower fees. These include Baron Partners Fund BPTRX, -2.71% , Hussman Strategic Growth Fund HSGFX, +2.07% and CGM Focus Fund CGMFX, -3.35% .
What to watch out for:
Membership has its price
To be free from certain restrictions, hedge funds limit access to investors who regulators deem rich and savvy enough to handle the risk.
An accredited investor is someone with a net worth, or joint net worth with their spouse, of more than $1 million. Or they can have income that exceeded $200,000 in each of the two most recent years or joint income with their partner of more than $300,000 for
those years, according to the SEC Web site.
Hedge-fund buyers would do well to remember Groucho Marx's quip: "I do not care to belong to a club that accepts people like me as members." Beware easy access. To be properly diversified, an accredited investor in fact needs much more than $1 million in net worth so they can invest in several different managers and a variety of assets, Cordaro notes.
Lower minimums, limited opportunity
More accessible hedged mutual funds often have less flexible tools and strategies at their disposal. Hedged mutual funds provide daily pricing and valuations, so underlying investments need to be fairly liquid and relatively easy to value, Cordaro explains. But hedge funds often can take advantage of less-liquid, more complex securities in search of higher returns, and some have expanded into private equity, he adds.
"You'll miss some of that component in these (hedged mutual-fund) strategies," Cordaro said. "I'd prefer the full hedge fund format because you're getting more of what a hedge fund is supposed to be."
Fees and taxes
Even investors who qualify for traditional hedge funds have several issues to consider.
Typical charges are 2% in management fees and 20% of profits each year. Those high fees attract the best managers but can also eat into returns. Funds of hedge funds often charge 1% in annual management fees and 10% of profits. There, investors pay two layers of fees.
Hedge funds also usually trade much more often than mutual funds. That can generate larger tax bills.
Indeed, hedge fund investors may give up about half of their returns each year in fees and taxes, estimates Vladimir Belinsky, president of Hermitage Advisors Ltd. which advises high-net-worth buyers on investments such as hedge funds.
Some hedge funds can generate returns lucrative enough to diminish the effect of taxes and fees, but annual gains have to be around 20% for that, he noted.
Leverage and short selling
Leverage and short selling are crucial tools that can help hedge funds generate steady gains even if markets are falling. However, they also present potential risks that traditional mutual funds don't face.
A short position can lose an unlimited amount of money as the security in question keeps rising. In contrast, a long position can fall no further than zero.
Leverage, or borrowed money, can magnify gains, but can also exacerbate losses and force some managers to sell positions into weak markets.
"The ability to use leverage is important, but you also have to understand that it adds dramatically to the amount of risk you're taking," Cordaro said. "Highly leveraged strategies work very well and provide consistent returns until you have a market-disrupting event and then you can have a horrible month or a complete meltdown."
Lockups and lack of liquidity
Hedge funds don't let investors withdraw their money daily like mutual funds. In fact, most hedge funds have so-called lockups of at least three months. Some tie up clients' money for as much as three years.
"Gates" are also common. A gate limits the proportion of a fund's capital that can be withdrawn by investors. If investors representing a big enough portion of a hedge fund's assets clamor for their money, the gate comes down and all redemptions are frozen.
Lockups and gates help hedge fund managers invest in less liquid assets and securities. But investors need to know that their money could be inaccessible for long periods.
"Investors should understand the lockup rules and know that these issues can determine the type of manager they can access," said Daniel Strachman, founder of consulting firm A&C Advisors LLC and author of several books on hedge funds. "If you think you're going to need the money for something within a short time, you probably shouldn't be investing in hedge funds."