Many would argue that hedge funds have the distinctions of being the most important investment product Wall Street has created in the last 70 years and the least understood instrument.
There are many reasons why both investment professionals and investors cannot seem to figure out hedge funds. A major reason is all the negative information that is disseminated by the popular press about these so-called "secretive" investment vehicles, while another is the lack of information that is available outside the popular press. For example, more than 1,000 Web sites provide information on stocks, bonds and mutual funds, but fewer then 50 provide information on hedge funds.
The ironic part is that most hedge fund managers and, more important, hedge fund investors don't seem to care that the mainstream press and the investing public have ostracized them. For the most part, both groups basically are laughing all the way to the bank, not only because their returns have been so strong in the last few years, but also because many so-called investment professionals and investors are not interested in what hedge funds do and how they do it.
Hedge funds, for those of you who don't know, were created in the late 1940s and early 1950s by a sociologist turned journalist named Alfred Winslow Jones. He had the idea that if he took an investment portfolio and split it into two groups of stocks, one that invested in the long side of the market and one that invested in the short side, he would be able to "hedge" the risk of the portfolio and, in turn, perform better than if he simply took all the assets and went long as most people were and continue to do.
Over the last 50 years, hedge funds have evolved into more than just long and short equity investment products. Today, there are funds that trade all types of investments ranging from equity and fixed-income funds to currency and futures funds and every variation thereof. And while each fund may be different, they all have a few of the same characteristics. For example, they are limited to accredited investors, and depending on the structure, they are limited to either 99 or 499 investors. For the most part, they all charge a management fee and an incentive fee, usually 1% and 20% respectively.
The real problem with the hedge fund industry and the reason why many people don't understand the vehicles and how they work is the lack of information about them. Unlike mutual funds or other investment products, it is hard to get information on hedge funds. This lack of information has caused many to believe that hedge funds are doing something wrong or acting improperly and in turn has created a certain veil of secrecy around the industry.
Regardless of market perceptions, these products should not be overlooked. In fact, most financial professionals, including me, believe that the media and many financial planners are doing the hedge fund industry and, more important, investors an injustice because of the lack of information they are providing about the products. Hedge funds should play a critical role in any diversified financial plan.
I believe that any financial planner who works with accredited investors and does not tell clients about hedge funds, how they work and why they are an important part of a diversified portfolio is not fulfilling his or her fiduciary responsibility to these clients. Hedge funds by nature are less risky than mutual funds because they are able to go both long and short and, as such, have been performing better than most broad-based mutual funds and their respective indexes this year. According to Van Hedge Fund Advisors, a Nashville, Tenn.-based consulting firm, the average U.S. hedge fund provided a 1.9% net return to investors through the end of October while the Dow, S&P 500 and Nasdaq remained heavily negative for the same period date, with losses of -14.7%, -18.9% and -31.4%, respectively.
Hedge funds are able to take advantage of more different types of investment opportunities and, in doing so, are able to capitalize on both sides of the market as opposed to most mutual funds, which are only able to go long. Also, most hedge fund managers "put their money where their mouth is," meaning that their success is tied to that of all the investors. There are very few mutual fund managers who can make this claim.
While the popular press would have you believe that all hedge funds are corrupt, evil and interested in generating fees, I would argue that this is just a ploy to sell newspapers and, in one particular case, magazines. There are very few hedge fund managers who bet it all on one trade or trade by the seat of their pants. The whole idea behind hedge fund investing is to take calculated risk, make trades that will enhance the performance of the portfolio and, most important, preserve capital.
Yes, there are some funds that have experienced problems and blown up. But for the most part this is not the case, and any financial planner or investment professional who doesn't look to provide clients with access to hedge funds is not providing them with sound advice.
Daniel A. Strachman is the author of Getting Started In Hedge Funds and the forthcoming Essential Stock Picking Strategies. He is managing director of a New York-based investment-management firm. He can be reached at firstname.lastname@example.org.