There are plenty of investing options available to astute financial advisors. The realm of alternative investments is large. It includes investment vehicles such as hedge funds, venture capital funds and private equity funds. These offer unique advantages but they come with risk profiles different than those of mutual funds and exchange-traded funds.
What Are Hedge Funds?
In this article, we will take a look at hedge funds in particular. Various types of hedge funds have been in existence for the past 50 years. The original intent of this investment category was hedging of portfolios of stocks or bonds, but the term today refers broadly to any private investment fund that has a fixed management fee based on asset size and an incentive profit-sharing arrangement. If you look at hedge fund databases (provided by Bloomberg, Morningstar or other firms), you will see classifications like directional equity, global macro, event driven, fixed-income arbitrage and so on. The terminology can be intimidating, but in essence, these funds invest long and short in stocks, bonds, currencies or commodities, in the U.S. or globally, sometimes hedged by indexes, futures or ETFs.
Why Should You Consider Hedge Funds?
Properly researched and selected hedge funds should be a part of a balanced portfolio for affluent investors. Please keep in mind that hedge funds can be offered only to accredited and qualified investors, i.e. those with net worth above $1.5 million (there are other criteria for accredited investors but this is the simplest and superceding requirement). Mutual fund and ETF investing can be great during bull markets, but they do not have downside protection or hedging, which is provided to some degree by many equity long-short funds. Second, a hedge fund manager usually has a strong incentive to perform well to achieve absolute returns. Mutual funds on the other hand, are focused on returns superior to benchmark indexes. In 2008, many hedge funds performed better (or less badly) than mutual funds and market indexes. Hedge funds also provide you with investing strategies not available through other kinds of investments.
Five Steps To Selecting Hedge Funds
Investing in hedge funds is not easy. Unlike mutual funds, there is little or no information available publicly on hedge funds, and that makes the task challenging for financial advisors. On the other hand, if you perform solid due diligence in selecting, you bring a significant value to your clients. Here are guidelines to use in narrowing your search:
Step 1: Understand Investment Philosophy
This may sound trivial, but it is amazing how often investors put money in funds recommended by their friends without knowing what the fund is really about, what type of assets it invests in, and importantly, what are the parameters under which it operates.
However, it's often not easy to find detail information on hedge funds. Their reporting requirements usually aren't as detailed as those for mutual funds. But there are a few ways to dig for more for information. The first is to talk to the manager and ask pertinent questions. Another way: Read past letters or quarterly reports sent to fund investors by the manager. Usually, a hedge fund manager will provide them to you when you request them (we do so), and they can offer insight into the hedge fund's investing philosophy by way of examples. Fund managers are generally reluctant to tell you about current positions, because making them public might result in others taking action that could hurt their strategies, especially for shorts. But if you are told the fund manager has proprietary trading techniques, or some esoteric formulas and gumbo-jumbo that are too difficult to explain to investors, that should raise a red flag. Stay away from black boxes (or should we call them Maddox boxes). True, some investment strategies are not simple, but if they are truly worth applying, you must spend time with the fund's offeree to understand well what the fund is about.
Step 2: Understand The Risk
Read offering documents (prospectus) carefully. What are the risks, what can go wrong? A well-known example is Amaranth, a multibillion dollar fund that lost over 50% in a matter of weeks in 2006 as its bets on natural gas futures turned disastrous. That fund used too much leverage and had concentrated bets - factors that amplified risk.
Assessing risk is tough. You have to ask questions. How much leverage does the fund utilize? What criteria does it follow for maximum exposure to a single security? How well does the fund manager execute its strategy? What checks and balances do they have in place? Leverage is a two-edged sword. Some fund managers get carried away with it, believing too much in their strategy. If it works, they are rewarded, if it does not work, the downside risk is higher compared to those funds that have little or no leverage.
Step 3: Assess The Manager
This is the most critical step. What qualifies this manager and his or her firm to invest your precious money? What is unique about this fund manager's firm and its principals? What is the background and experience of its principals? Fund salesmen are often good communicators with charming personalities, but you have dig deeper and evaluate the manager.