Can’t Afford a Hedge Fund? Study May Make You Feel Better About It
Hedge funds are the private clubs of the investment world.
They operate in relative secrecy. They limit their members to millionaires (most, in fact, are multimillionaires). They delve into complex, often speculative investments. They’re beyond the reach of most federal securities laws.
But does this mean hedge funds deliver better results than mutual funds?
Don’t bet on it. A recent report from New York-based Goldman, Sachs & Co. and Financial Risk Management Ltd. of London sheds new light on the risk and return traits of hedge funds.
The study examined the performance of four main classifications of hedge funds, grouped according to investment strategies and risk level, from 1993 through 1997. It found that, on average, hedge funds in all four categories trailed the Standard & Poor’s 500-stock index of blue chips.
That should bring a smile to the faces of mutual fund shareholders, most of whom couldn’t afford to invest in a hedge fund even if they wanted to. Although most mutual funds also didn’t beat the S&P; 500 over the five-year stretch, these populist investments roughly matched the performance of their upper-crust rivals.
Hedge fund enthusiasts say it’s not an apples-to-apples comparison. Hedge funds are better than mutual funds at reducing risk and avoiding losses, they say.
“What makes them interesting isn’t the high returns but the low risks,” said James Owen, a hedge fund manager at Husic Capital Management in San Francisco.
Indeed, the Goldman Sachs-Financial Risk Management report found that all four categories of hedge funds were less volatile than the S&P; 500 over the study period. The riskiness of mutual funds was not examined but is commonly assumed to be higher.
Hedge funds have greater flexibility than mutual funds to employ risk-dampening tactics. For example, it’s easier for them to sell short (i.e., bet that the price of a particular stock will tumble). When combined with regular stock investments (or long positions), short-selling can give a portfolio a market-neutral flavor.
Hedge funds also have more leeway to bet on currencies, leverage their portfolios, invest in private placement securities and the like.
“Hedge fund managers can use metal tennis racquets, while mutual fund managers are restricted to wood racquets,” said one executive at a California firm that runs both hedge and mutual funds. “Mutual fund managers don’t have access to all of the risk-reduction tools.”
But there’s a reason for that. Short selling and other common hedge fund tactics can cause serious damage to a portfolio if a manager miscalculates.
“Similar, if not identical, instruments were used in the 1920s and created a lot of the [stock market] problems of the ‘30s,” said Michael Lipper of Lipper Analytical Services, a mutual fund monitoring firm in Summit, N.J. Short selling was a factor leading to the crash of 1929.
Mutual fund investors also have more legal rights in the event a portfolio manager generates big losses because of reckless speculation.
“If you’re in a hedge fund, you’ve declared yourself to be a sophisticated investor,” Lipper said. “Therefore, you should know [the risks].”
Mutual funds must register with the Securities and Exchange Commission, and virtually all aspects of their operations are governed by law. Hedge funds are restricted by general fraud statutes but otherwise are unregulated companies bound only by the terms of the contracts they sign with investors.
However, a management company may be SEC-registered even if it runs private portfolios, says Owen, who recently published a 26-page booklet about hedge funds ($10; [415] 398-0800). He suggests that if you want to invest in one, that you ask if the firm is registered with the SEC and, if so, request a copy of the commission’s ADV form, which gives details on the firm and its money managers.
Other key distinctions between hedge and mutual funds include:
* Investment minimums: Mutual funds are open to anyone who can meet the account minimum--typically $1,000 to $5,000. Hedge fund minimums range from $100,000 to more than $1 million. Net worth requirements also apply. Depending on the fund, hedge investors either must have $1 million in assets and at least $200,000 in household income; or, if no income threshold, have $5 million in assets.
* Fees: Mutual fund fees, listed in standardized tables in the prospectus, typically range between 0.5% and 2% a year and are regulated. So are sales charges, which rarely exceed 5.75%. There are no fee limits on hedge funds. Managers typically charge 1% to 2% each year and take 20% of the fund’s annual profit.
* Leverage: Mutual funds are carefully regulated as to how much borrowing they can do. Hedge funds are under no such constraints. The higher-risk nature of some hedge funds makes them more prone to bankruptcy. That is something that is virtually impossible for a mutual fund.
* Liquidity: Mutual funds must redeem shares on demand during business days. No such rules govern hedge funds. Hedge investors can buy or sell only periodically--for example, once a quarter--and may face withdrawal fees. But the steadier cash flows of hedge funds can make them easier to manage, especially with their complex strategies in play. “A long-short strategy is very difficult if you have money coming in or out every day,” Owen said.
* Pricing: Mutual funds value their portfolios daily and disseminate this information to newspapers, monitoring firms and other sources. Hedge fund investors rarely know exactly what their holdings are worth at any moment, and may find it hard to value complex positions. Hedge managers may be “less willing than traditional managers to discuss specifically their investment process,” the Goldman Sachs/Financial Risk Management report said.
* Managerial concentration: Hedge funds typically are run by one or two key decision makers who have great confidence in their skills and act accordingly. Mutual funds, by contrast, frequently must adhere to a carefully defined investment style. Many also are run by teams or, at the least, are backed by analysts.
This makes a research effort more critical with hedge funds. For investors, “there’s more due diligence required than simply flipping through the pages of a Morningstar guide,” Owen said.
In short, although good hedge funds can be good investments, especially in a bear market, spotting future winners isn’t easy. Even if you can afford to invest in a hedge fund, you might not find the long-term benefits too compelling when you factor in the higher costs and skimpier protections.
So envy the rich their fancy cars, homes, yachts and wardrobes--but not their hedge funds.
Russ Wiles is a mutual fund columnist for The Times. He can be reached at russ.wiles@pni.com.
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No Edge for Hedge
Despite their exclusivity, hedge funds didn’t outperform the broad stock market from 1993 to 1997. Shown below are performance results for four categories of hedge funds, as identified in a recent report by Goldman Sachs & Co. and Financial Risk Management Ltd. They are shown in ascending order of riskiness, from market-neutral funds, the least volatile, to tactical-trading funds, the most volatile.
Over this period, the Standard & Poor’s 500-stock index returned 151%. By comparison, growth-and-income mutual funds returned 125%, according to Lipper Analytical Services, while sector mutual funds rose 119%, global funds 93% and balanced funds 86%.
* Hedge-fund category: Market-neutral
Basic investment approach: Conservative long/short, bond and derivative positions designed to eliminate stock-market risk
Total return, 1993-1997: +87%
* Hedge-fund category: Event-driven
Basic investment approach: Investments in “special situations” such as merging companies or firms facing bankruptcy or reorganization
Total return, 1993-1997: +122%
* Hedge-fund category: Equity long/short
Basic investment approach: Long/short positions designed to reduce market risk
Total return, 1993-1997: +142%
* Hedge-fund category: Tactical-trading
Basic investment approach: Speculative stock, commodity, currency or other investments
Total return, 1993-1997: +143%
* Sources: Goldman Sachs & Co., Financial Risk Management Ltd.
