A hedge fund is like a regular mutual fund with some key differences.
Hedge funds (a) pay an incentive fee to the manager based on the fund’s performance and (b) only accept a limited number of “accredited” (i.e., wealthy) investors in order to be exempt from Securities and Exchange Commission’s (SEC) regulations. Mutual funds are registered with the SEC, have significant reporting requirements, and are subject to limitations on short-selling and the use of leverage. Presumably, “accredited” investors are sophisticated and do not need SEC oversight. Hedge Fund Research Inc. estimates hedge funds had $1.9 trillion under management at the end of 2006. This compares to $10.4 trillion in mutual funds at the same time, according to the Investment Company Institute.
A dictionary definition of hedge is “to limit risk by a counterbalancing transaction.” Although some hedge funds reduce risks this way, many others increase a portfolio’s risks. For example, a Wall Street Journal article on June 14 discussed a Bear Stearns hedge fund started about 10 months earlier to invest in bonds backed up sub-prime mortgages. Bear raised more than $600 million combined with $6 billion in borrowings to create a fund with assets initially totaling about $6.6 billion. This hedge fund has been bombing. Bear is now trying to sell $4 billion of the bonds reportedly to free up cash for redemptions, margin calls or to close the fund.
Management fees are typically 1.5 percent to 2 percent of the assets under management. A fund with $6 billion in assets would have a management fee of $90 to $120 million annually. In addition, a hedge fund incentive fee is commonly 20 percent of gross returns although the fees vary widely. One hedge fund manager charges a 50 percent incentive fee with no management fee. Another charges a 5 percent management fee and a 44 percent incentive fee. In 2006, fees in one hedge fund totaled $1.5 billion. Some funds require the manager to (a) generate returns greater than a modest “hurdle” such as the returns of a Treasury bill and/or (b) increase the net asset value above its prior years’ high water mark before any incentive fee is earned. This is reasonable, but today the demand for hedge funds has outstripped the supply, and these provisions are now rare. Warren Buffett fears the incentive fees encourage managers to take excessive risks instead of focusing on long-term returns. Finally, some financial institutions sell “Fund of hedge funds” to spread risks among several hedge funds. These institutions perform due diligence and some investor services. Typical fees for their services are an additional 1 percent management fee and a 10 percent incentive fee.
Its two-decade record of 15.4 percent per annum returns produced a 2006 Endowment value more than 10 times that of 1986. David Swenson, its chief investment officer during this period, spoke at a CFA Institute conference in New York last month. In his speech, I was surprised that Yale has only 31 percent of its funds in traditional investments–cash, bonds and stocks. The rest is in hedge funds that exploit market inefficiencies through active management employing three strategies:
1. Absolute Return Strategy. About one-half is event-driven transactions such as a merger, spin-off or bankruptcy restructuring. Yale looks for buying or selling opportunities to exploit. The other half is value-driven opportunities in which a hedged position (for example, a S&P500 futures contract) is not priced in line with the underlining asset.
2. Private Equity Strategy. Yale invests in venture capital and leveraged buyout partnerships. Since inception, it has provided a 30.6 percent annualized return. This is due to an emphasis on a value-added approach to investing, a long-term association with the best and a close alignment of the general and limited partners’ interest.
3. Real Assets Strategy. The illiquid nature of real assets (real estate, oil and gas, and timberland) combined with the time-consuming process of completing transactions, create a high hurdle for casual investors. Yale builds strong, long-term partnerships with talented managers of real assets which has generated a return of 17.4 percent per year since inception (1978).
Hedge fund managers resist disclosing details of their investing out of fear that others will adopt them, causing opportunities to disappear. Casual investors frequently accept this lack of information. Regardless, Yale’s David Swenson said that if he recommended a hedge fund to Yale’s Board without knowing how the money would be invested, he would and should be fired. Yale requires complete transparency and the alignment of Yale’s and the managers’ financial interests. David said the three keys to successfully invest in hedge funds are people, people and people.
The hedge fund industry has exploded. Uncovering market inefficiencies are more difficult and less rewarding. High management and incentive fees are big negatives. For the casual investor, seek a hedge fund with very low (or negative) correlation with your portfolio and equity-like returns.
Next month: Prescription Drug Costs.
Roger E. Muns, CFA and CPA, of Wealth Management, LLC, is president of Chartered Financial Analysts Society of Mississippi and may be reached via firstname.lastname@example.org.