There are many legitimate reasons to shun hedge funds.
They are expensive—typically
charging fees of 2% of assets under management and 20% of any profits. They
often have lengthy lockup periods, so you aren't always able to get your money
back when you need it. And there are so many funds with inconsistent records
that it is a challenge finding a manager whose performance justifies the steep
fees.
Yet there is one criticism that has been leveled at hedge
funds recently that is unfair: poor performance relative to the S&P 500.
Since the bull market began in March 2009, the critics
will point out, the average hedge fund in the Credit Suisse Hedge Fund Index
has gained an annualized 8.5% through April 30, versus 23% for the S&P 500,
assuming dividends were reinvested. Over the past 10 years, even a conservative
portfolio that invested just 60% in the S&P 500 and kept 40% in bonds still
outperformed the average hedge fund.
But most hedge funds aren't designed to outperform a
rising stock market. Though some do try to shoot the lights out,
performance-wise, most seek to generate steady gains—or at least minimize
losses—in all types of markets.
"Hedge funds shouldn't beat the stock market in
raging bull markets, or fall as much in huge bear markets," says Cliff
Asness, founding principal at AQR Capital Management, which oversees $105
billion in hedge funds and other investments.
This was certainly the case during the bear market that
lasted from October 2007 through March 2009. The Credit Suisse Hedge Fund index
lost an annualized 12% over that period, compared with the S&P 500's 39%
drop.
And consider that institutions
and wealthy individuals—including some of the savviest investors around—have
poured billions into hedge funds in the past two years, pushing assets to a
record $2.7 trillion, according to researcher HFR. Clearly, they see some
value.
So, with the pros and cons on
the table, here are some things you should think about if you decide to join
the hedge-fund club.
What to Consider
First, it is a complicated
business. The wide range of strategies employed by hedge funds includes taking
bets on macroeconomic developments around the world, on events such as mergers
and acquisitions and on other asset classes besides stocks and bonds, such as
currencies and commodity futures.
In choosing among them, you
need to consider the role you want a hedge fund to play in your portfolio. Are
you looking for positive returns—even small ones—in all markets, or are you
gunning for potentially big gains? Or do you want to invest in assets that
behave differently than either the stock or the bond market?
Then you will need to find a
fund. That is hard because of the complex analysis required to determine
whether a hedge-fund manager is truly adding value, according to Vikas Agarwal,
a finance professor at Georgia State University who has studied the industry.
For example, he said in an interview, "the techniques used to assess
mutual-fund managers do not apply to hedge-fund managers."
Furthermore, the databases
containing reliable information on individual hedge-fund performance can be
prohibitively expensive for individuals. And even if you find one, many of the
big-name fund managers with superb records may not be accepting new cash.
You may therefore want to
engage the services of a financial adviser who has access to the requisite data
and the statistical acumen to analyze hedge fund performance.
You may find it easier still
to invest in a fund of hedge funds. Though such vehicles have the disadvantage
of adding yet another layer of fees, you get the benefit of professional staff
that does the work of sifting through the thousands of hedge funds that are
available.
Be aware, however, that in
order to invest in either a hedge fund or a fund of hedge funds, you will need
to be an "accredited" investor, which the Securities and Exchange
Commission defines as an individual whose annual income tops $200,000 or whose
net worth exceeds $1 million, excluding a primary residence.
Click here
for the full article in the Wall Street Journal.