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 hot -- so watch out!
The number of hedge funds has quadrupled since 1990, to more than 8,000, according to Van Hedge Fund Advisors. Assets under management have grown 20 times, to more than $800 billion. By 2008, Van predicts that that figure will more than double, to $1.7 trillion.
Any time investors move in large packs, it's wise to step back for a moment. For starters, it's hard to imagine that the number of highly skilled hedge fund managers has quadrupled since 1990. What's more, the flood of money may be squeezing the profits out of the most popular hedge fund strategies, such as fixed-income arbitrage (exploiting unusually high differences in yields between similar bonds of different maturities). "If a whole lot of dollars are chasing one particular market strategy, it will be harder and harder to come up with market-beating returns," frets Columbus, Ohio, financial planner Tom Davison, who does not use hedge funds in his clients' portfolios.
A study last year by Citigroup Asset Management found that returns for 11 of 12 popular hedge fund strategies had deteriorated since the early and mid 1990s. Today, "much of the potential upside may be gone," says strategist Tobias Levkovich of Smith Barney, a Citigroup unit.
Past-performance figures may mislead.
Hedge fund management is a Darwinian field. As you'll see shortly, hedge funds fail at a high rate, and that attrition distorts performance numbers. Here's why: Hedge funds aren't required to report their returns publicly. Those that do, do so voluntarily to private firms that track hedge fund results. Funds that perform poorly are less likely to report results, and funds that go under are thereafter excluded from the indexes. Thus, results for remaining hedge funds -- the survivors -- are "substantially" overstated, according to a study by Burton Malkiel, a Princeton professor, and Atanu Saha of Analysis Group, a research firm. Three widely cited hedge fund indexes reported annualized returns ranging from 13% to 14% from 1996 through 2003. But the figure was really just 10% annualized when adjusted for survivorship bias, the study says. (Mutual fund returns also suffer from this bias, but less so.)
The study also found a wide gap between the top-performing hedge funds and the rest of the pack. Such gaps exist in mutual funds, but they are modest by comparison. With hedge funds, say Malkiel and Saha, you take on "a substantial risk of selecting a very poorly performing fund -- or worse, a failing one."
You need to be well-off to get in to hedge funds.
To qualify, you must have annual income of at least $200,000 ($300,000 for a couple) for the past two years or $1 million in net worth (which may include the value of your home). Some funds raise the bar, requiring $1.5 million to $5 million.
It's not snobbery that compels hedge funds to reject the less well-off. It's Congress. To avoid regulations that apply to mutual funds and other mass-marketed investments, hedge funds must limit sales to investors who (in Congress's view) are sophisticated enough to understand the risks.