So you wanna buy a hedge fund, eh?
Hedge Funds are hot!. After a couple of years of outflows, hedge funds are back in vogue. But before the taxable investor jumps into a fund or a fund of funds, there are a few things to consider. Among the most important: While hedge funds can deliver outsized rewards, they can be significantly more risky than many other types of investments.
Understand your market risks. While all investors realize that they have to take some risk to earn positive real returns, it is important to consider the source of the returns. When you look at investing in a single hedge fund manager or a fund of funds, are the returns consistent with the returns available in the areas in which they invest? Madoff supposedly achieved double-digit returns in an investment strategy in which mid-single digits were the norm. While there are some superstar managers, massive outperformance over short periods of time usually signals either significant style drift or highly leveraged bets. Your hedge funds should have investment processes that are understandable to you and repeatable by them. You want to make sure you are getting adequately rewarded for the actual market risks your manager is taking.
Beware the asset gatherers. Many hedge funds with long track records tout market-beating returns from inception. But don’t forget the power of compounding. That manager who has an 18% annualized return over the last five years might be riding the benefits of a huge first year or two, when assets were probably much smaller. (Do the math: 55% in year one, followed by four 5% years is more than 18% annualized.) There is a significant body of research that suggests the returns earned by funds between $500 million and $1 billion are significantly better than those earned by funds over $1 billion. Some managers will continue to raise as much money as possible, even though the additional assets might make it all but impossible to earn significant risk-adjusted returns in their market segment.
Understand The Fees. A typical hedge fund works on the “2 plus 20” fee formula. They get 2% of the net asset value of the fund in addition to 20% of the profits. The manager typically makes more on management fees than on performance fees if the underlying returns are less than 12%. In fact, a 2% fee is more than the fee assessed by the average stock mutual fund. Then there is the 20% profit share. Investors really need to think whether their hedge fund manager has the ability to outperform the historical performance of the S&P 500.
Don’t get us wrong. Hedge funds can be a terrific investment for the right investor. But they need to be carefully considered. In my next blog I will discuss liquidity and transparency, after tax returns and the “alignment of incentives.”