Hedge Funds as an Investment, Pt. I

On July 22, 2008, Bankaholic posted an article entitled "4 Reasons Why Investors Should Avoid Hedge Funds at All Costs" by John Wu, who warns investors that "four curious characteristics of hedge funds make them different than many standard investments."

Investopedia introduces the concept of a "hedge fund" as follows:

An aggressively managed portfolio of investments that uses advanced investment strategies such as leverage, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). * * *

Wikipedia begins its extensive description of a "hedge fund" as follows:

A hedge fund is a private, largely unregulated pool of capital whose managers can buy or sell any assets, bet on falling as well as rising assets, and participate substantially in profits from money invested. It charges both a performance fee and a management fee.

Typically open only to qualified investors, hedge fund activity in the public securities markets has grown substantially, accounting for approximately 10% of all U.S. fixed-income security transactions, 35% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, and 30% of equity trades.

Hedge Funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt. * * *

Mr. Wu, in his article, acknowledges the high profile and wide availability of hedge funds as private investments promoted as attractive to wealthy investors.

He then cautions: "But if anything in this description of hedge funds surprises you or makes you the least bit uncomfortable, then it might be best to stick with what you know."

With copyright permission granted today from a representative of Bankaholic for reproduction on this Blog, I now post the four "curious characteristics" of hedge funds described by John Wu. For his cautionary introductory comments, read the full article .

1. Lack of oversight:

The SEC does not require a private investment fund to register with them or any other regulatory body if it is comprised of fewer than 100 investors. Combine this with these funds’ tendency to lean heavily on offshore investments and hedge funds are operating in a virtual vacuum.

While too much government oversight can hamper the performance of an investment vehicle, too little means that the people handling your money aren’t accountable to anyone, including you.

2. Managers with little to lose:

When investors are invited to contribute to a hedge fund, the manager sets a high-water mark for returns. If your manager meets this goal, he will retain a full 20 percent of your returns, in addition to the couple of points in assets that he is already collecting on an annual basis. And what happens if your fine manager doesn’t meet this lofty goal? With all that he has to gain, failure must destroy him, right?

In fact, you and your fellow investors will eat all of the losses and your manager will merely move on and set up shop somewhere else, none the worse for wear.

3. Totalitarian mindset:

When you invest in a hedge fund, you are putting your assets entirely in the hands of one single person, and that is a dicey proposition any time that that person isn’t yourself. The manager of the fund makes all of the investment decisions that determine the success or downfall of the fund, and even a manager with a great track record is fallible.

If your manager gets in a fight at home or catches a flu bug, your portfolio could suffer. Worse yet, if your manager steps down and hands the reigns to someone completely new, you and your fellow investors could be in serious trouble.

4. Short life spans:

The average life of a hedge fund is only three years, which means that employing this vehicle is unwise if you have a long-term strategy in place. One out of every ten hedge funds collapses each year, making this industry as volatile as almost any other venture out there.

An investment with such a short shelf life might not be the way to go if you are a typical investor who has the long haul in mind.

Mr. Wu's comments are directed towards individual investors. But, for me, his last statement invokes images of fiduciary investors who are responsible over a "long haul" for the benefit of others and who are liable under legal standards of conduct.

What should a fiduciary know about hedge funds?

In tomorrow's posting, I will reference a recent, detailed, authoritative resource that can provide guidance and standards to fiduciaries in dealing with hedge funds.

Graphic source: Article, "Hedge funds and dirty tricks" (03/24/08)
posted by Sox First
a management & compliance company based in the United Kingdom.

Update: 07/25/08:

For the second part of this series, see: EE&F Law Blog posting "Hedge Funds as an Investment, Pt. II" (07/25/08).

Update: 07/28/08:

For an article with a different viewpoint, see: "Ignore the Press: Hedge Funds Still a Viable Investment" (07/24/08) posted by Greg Boop on the Seeking Alpha website.

In that article, he mentions Hedge Fund Info posted by HingeFire, which contains explanations & some industry reference links.

Update: 09/06/08:

NBC News broadcast a Dateline NBC segment by correspondent Dennis Murphy on Friday, September 5, 2008, at 10:00 p.m., entitled "Mystery of the missing millionaire."

A wealthy hedge fund manager whom the rich and powerful trusted with their fortunes suddenly disappears – and the money was gone too. Turns out, all along he'd been playing a dangerous game with very high stakes. Dennis Murphy reports.

The description of the investigative report explores "hedge funds" and their managers, and reinforces some of the concerns expressed in recent years:

This giddy era, before the market’s recent swan dive, was dubbed “the new gilded age” and some of the young men becoming as rich as any Rockefeller or Andrew Carnegie of days past were masters of something known on Wall Street as a "hedge fund."

Top hedge fund managers have been reported to make anywhere from $100 million to a billion dollars a year. They do it by making already wealthy people and institutions even richer.

Someone who wanted in on the hedge fund action in the worst way was Samuel Israel III. He was a Wall Street guy who’d worked his way up here and there in the ‘80s and ‘90s as a trader. * * *

A hedge fund, like the one Sam Israel was starting up, is like a private club for wealthy investors. It usually takes a million dollars to get in the door.

And the very best hedge fund managers are a high priesthood of brilliant traders. They place complex bets that can pay off handsomely, even when others are losing their shirts. * * *

The website for the recent broadcast segment referenced a previous helpful MSNBC commentary, "What is the deal with hedge funds?" (08/27/07), by John W. Schoen, Senior Producer.