The Hedge Of Reason

April 10, 2006
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GRAND RAPIDS — The modern hedge fund uses state-of-the-art technology to produce stellar returns using the safest investment vehicle possible. But in the world of investing, “safe” is a relative term.

In recent years, strong yields from hedge funds have gone a long way to fill the gap left by the collapse of the late 1990s technology stock craze. While hedge funds have become more popular, they don’t offer the same level of accessibility and flexibility of traditional investment vehicles, such as equity trading accounts. But, the same changes in technology that allowed millions of small-time investors to get a piece of the dot-com boom may be changing the way people invest in hedge funds.

According to one local financial adviser, that could be a bad thing.

Hedge funds are, in simple terms, pools of capital that are invested through a specified strategy in order to maximize returns and minimize risk. Hedging, according to Forbes’ financial glossary, can involve “using call options, put options, short selling or futures contracts. A hedge can help lock in existing profits. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss.”

How a hedge fund manager chooses to go about reaching that goal varies wildly from fund to fund. For that reason and several others, putting money into an investment class that’s designed to offer stability and limit volatility could be a risky bet for some investors.

“It’s all driven by human behavior: the quest for a high return. Everyone wants a high return,” said Bill Walker, CEO of Legacy Trust, an independent trust bank that provides financial management services for high-net-worth investors.

Walker feels that some of the recent success of hedge funds may be attributable to the media coverage they have received.

“You’ve got to ask the question: With the explosion in hedge funds, especially in the last five to seven years, were all the returns that were generated based on the opportunities that the market was presenting, or was it self-fulfilling — in that the market growing created the returns, just like the way tech stocks ran up in the ’90s?”

Walker does not advise against investing in hedge funds. But he feels that they are right only for certain individuals — specifically, experienced investors with well-diversified portfolios.

He feels this way, in part, because of the lack of transparency in hedge funds. Unlike investments in a traditional vehicle, such as a mutual fund, hedge funds don’t require regular filings with the Securities and Exchange Commission. Most of them don’t offer the daily pricing information available with individual stocks or mutual funds. Many also require substantial up-front investments and multi-year lock periods wherein the investor cannot withdraw funds.

“You’re delegating a whole bunch of faith to a manager of a hedge fund who hasn’t really set out any particular parameters as to how it’s going to be done,” he said.

“He can describe the strategy, but not necessarily: ‘This is what we’re going to own and these are the types of industries we’re going to be involved in.’”

In some cases, that means that the investment strategies of the fund manager are riskier than those presented in the initial pitch to investors. As Walker put it, hedge funds contain all of the risks of traditional investments, plus many others depending on the style of the fund manager.

“Using a betting analogy, you’re trying to manage risk. So what is the risk of my putting chips down on the (roulette) table and having it come up red or come up black? You can kind of manage that risk. But then you start elaborating on that and saying, ‘Now I’m going to go for 2 red.’ Now you’ve got compounded risk of not only color but of number,” he said.

“In traditional investments, you have certain amounts of risk … but those are very manageable. So investors can take that kind of risk. Hedge funds as an asset class introduce several kinds of new risks on top of those traditional risks.”

Not just anyone can invest in a hedge fund. To become involved, one must be what the SEC calls “an accredited investor.” That means being either a bank, a nonprofit organization or a trust with assets over $5 million, an individual with a net worth over $1 million, or, at the bare minimum, an individual with a combined household income of over $500,000 for the two years prior to attempting to become accredited.

That doesn’t mean a smaller investor can’t get into the hedge fund action. Two new investment classes have come into being that don’t require the same level of financial wherewithal needed to be a direct investor in hedge funds.

The first is the “hedge-like” mutual fund. As the name implies, it is a traditional mutual fund that employs strategies akin to those used by hedge fund managers. These funds are being offered by an increasing number of traditional investment banks.

The other new investment class is the “fund of funds.” This entails an institution investing in individual funds, then selling shares in the collected investment pool. By having their money spread across a number of hedge funds, fund-of-funds investors further reduce their risk (on paper). They also increase their fees. That’s because there are two layers of administration: the services of both the individual fund managers and the fund-of-funds manager.

Keith Black, a professor of finance at Illinois Institute of Technology and author of “Managing A Hedge Fund,” said that with the emergence of the funds of funds and the hedge-like mutual funds, the industry is getting somewhat crowded. But, for the informed investor, some of the specialized hedge funds now available allow for the design of a more “defensive portfolio.” Even as a proponent of hedge funds, he said that he would advise against any investor putting more than 20 percent of a portfolio into them.

The SEC has compiled a fact sheet about hedge funds. It can be found at www.sec.gov/answers/hedge.htm.    

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