Would Participation in a Hedge Fund Be Right For You?

With recently announced changes in how the SEC regulates certain aspects of the hedge fund industry, it might be appropriate to consider just how suitable this type investment might be for individual investors.

The basic concept of hedged investing is relatively straight forward: buy long what you like and sell short what you don’t. This strategy was probably first established by Benjamin Graham, generally considered to be the “father” of deep value stock investing and the spirit guide of Warren Buffet. Reportedly, Graham, nervous about the strength of the markets during the late 1920s, developed the concept of hedging to offset some of the risks, while retaining positions that could continue to advance.

What has evolved out of this are the modern “hedge funds” that incorporate a broad range of strategies, with very little in common other than the pooled-investment legal concept. There really is no such thing as the “average” hedge fund (see below). Individual managers pursue different strategies, in a wide range of asset classes and diverse investment goals. Fund management is critical to the success of the fund. Potential investors should understand the extent to which the operation of the fund is consistent with their objectives. This is even more important when you consider that some managers have several funds, each with materially different strategies.

Because of the diversity of strategies, it is not practical to talk about average performance, which appears to have been exactly that, “average”, or generally in line with the market as measured by the major averages. Hedge fund managers that tend to garner the most press are those that seek outsize gains through aggressive strategies that can provide news-making gains or crushing losses. The common “2 and 20” management fee model is asymmetrical and tends to over-reward exceptional performance and only minimally penalize failure. Under the 2 and 20 model the investor pays an annual fee comprising 2% of the amount invested plus 20% of the profits. This can result in a big payday for successful, aggressive managers. Unfortunately, the investors always pay the 2% and incur 100% of the losses. In every investor/advisor relationship, it is important to completely understand fees and how they might influence advisor behavior.

It is also worth noting that typical hedge fund agreements severely curtail the ability of investors to withdraw funds. Most common stock investments allow for almost instantaneous liquidity, allowing investors to “cut their losses”. Withdrawal of investments in a hedge fund can take months and sometimes only partially at that. Oh, and by the way, you have to be an “accredited investor”, defined as having a net worth of more than $1 million, excluding the value of your primary residence, or an annual income of more than $200,000 for at least the last two years.

So, would a hedge fund be right for you? Assuming that you are an “accredited investor”, you’re able to assess and accept the manager’s strategy, you can live with an asymmetrical and probably excessive fee structure and you aren’t worried about liquidity, perhaps the answer is yes.

All comments and suggestions are welcome.

Walter J. Kirchberger, CFA