9 Simple Truths About Hedge Funds
Cloaked in secrecy, hedge funds operate outside the box and without government regulation. Be sure you know what you're getting before you take the leap.
By David Landis, Contributing Editor
From Kiplinger's Personal Finance magazine, March 2005
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Hedge funds are the rock stars of the investing world. Their behavior may make you cringe, but not enough to turn you off entirely. They manage to cultivate an air of mystery, in part because their dealings are often secretive, but also because they're available only to the wealthy few.
What exactly is a hedge fund? It's like a freewheeling mutual fund that operates largely without investing restrictions and government regulation. Hedge funds pursue a variety of strategies, from taking big stakes in failing companies and turning them around (as ESL Investments did with Kmart) to betting on the future price of oil.
This outside-the-box approach sounds terrific, especially given many professionals' pessimistic outlook for stock and bond returns. But before jumping in, there are some things you need to know.
Hedge funds can make money, even when markets sink.
Face it: The best that most mutual fund managers can hope for is to beat the market by a few percentage points in good years, and to lose a little less than the market in bad years.
Hedge funds take a different tack. They aim to show positive returns every year, regardless of the market environment, maybe by investing in such things as commodities and currencies that don't move in tandem with stocks and bonds. More often they try to profit when stocks and bonds falter, either by shorting (selling borrowed shares, then buying them back later at a lower price) or by buying derivatives, such as put options. Or they may buy stocks they like and short those they don't.
This often-defensive approach means hedge funds should outperform the market during down years, but underperform when stocks and bonds are doing well. In 2000, 2001 and 2002, all down years for stocks, the Van U.S. Hedge Fund Index outpaced Standard & Poor's 500-stock index by 21, 18 and 22 percentage points, respectively. In 2003, the 20% return of the Van index trailed the S&P's big gain by nine percentage points. In 2004, a more subdued year for stocks, the hedge fund index gained 8%.
Hedge funds can reduce the overall risk of your portfolio.
By pursuing strategies that aren't dependent on the results of traditional markets, hedge funds can cushion your portfolio against violent price swings in stocks and bonds. "We're trying to provide ballast rather than octane," says David Anderson, a managing director at GAM, which runs hedge funds as well as mutual funds. For example, between 1990 and 2003, a portfolio composed of the S&P 500 index, a bond index and a hedge fund index returned an annualized 11%; the best of several stock-and-bond portfolios returned only 10% annualized, according to a study by the Center for International Securities and Derivatives Markets at the University of Massachusetts. The portfolio with hedge funds also exhibited less volatility.