Do You Really Understand Hedge Funds?

If think you'd find yourself mumbling an answer to this question, take comfort in knowing that you are not alone. Other than sensing that hedge funds have a somewhat exclusive, yet secretive, allure and are great for name-throwing at cocktail parties, most people (even people who own them!) don't really know what they are.

Bob Frick wrote an article for the November 2011 issue of Kiplinger which we think may help provide a better understanding. Below are extracts from his article.

What exactly are hedge funds?
They’re private investment funds for the rich. A broader, if somewhat cynical definition comes from hedge-fund manager Cliff Asness of AQR Capital: “Hedge funds are investment pools that are relatively unconstrained in what they do. They are relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do. They are supposed to make money all the time, and when they fail at this, their investors redeem and go to someone else who has been making money.”

Then why the hedge-fund mystique?
It mainly comes from some big-name managers, who win and lose billions on gutsy bets and wield immense financial power. For example, hedge-fund rock star George Soros bets on how currencies will rise or fall, and he is so influential that his opinions can affect a currency’s value. John Paulson made billions by betting against mortgages. The dark side of this mystique is hedge funds gone haywire. In the late 1990s, Long-Term Capital Management goofed in its bets on European, Japanese, and U.S. bonds, and it had to be bailed out under the direction of the Federal Reserve Bank of New York.

What does hedge fund mean?
The first was started by Alfred Winslow Jones in 1949, and it truly was about hedging - protecting against losses. Jones figured that by buying stocks he thought would do well in the long term and then selling short stocks he predicted wouldn’t do well (a strategy to profit when prices drop), he would limit or eliminate losses. However, over the years hedge fund became an umbrella label encompassing all the strategies these funds use. Today, less than 30% of hedge funds follow Jones’s long-short strategy.

We should also note that long-short funds didn’t cover themselves in glory during the meltdown of 2008. Morningstar reports that the average fund lost 18.6% in 2008, about half the loss of Standard & Poor’s 500-stock index. And their performance since the market bottomed in March 2009 has been less than one-third that of the S&P 500.

What are the funds’ other strategies?
Data firm Hedge Fund Research lists four major categories with 27 subcategories (and ten sub-subcategories). But hedge funds mostly do a few basic things in addition to the long-short strategy. They use futures to bet on the direction of currencies or commodities. They profit from differences in prices between two or more markets—buying cheaply in one market and selling at a higher price in another. Merger arbitrage seeks to profit from the likelihood that an announced merger will actually go through. Because many of these strategies are risky, about one in four funds are combinations of funds, which can decrease volatility.

How big is the hedge-fund market?
Big. The 9,400 or so hedge funds hold just over $2 trillion in assets. By comparison, 7,600 mutual funds -- including ETFs, closed-end funds and unit investment trusts -- have about $12 trillion in assets. But hedge funds use leverage -- meaning borrowed money -- far more than mutual funds, so their impact on markets is disproportionately larger. A relatively small number of funds dominate the hedge-fund industry, with 63% of hedge-fund assets managed by less than 10% of the funds.

The market crash in 2008 has stunted the growth of hedge funds. That year, assets actually fled the industry -- a first. (Investors withdrew about $154 billion in 2008 and another $131 billion in 2009.) Since then, the flow of assets into hedge funds has resumed, but it has slowed since the funds’ heyday in the 2002–07 bull market. The number of new funds is also down.

How have hedge funds performed?
They’ve been mediocre, overall. A recent paper in the Journal of Financial Economics says that from 1980 through 2008, the average hedge fund returned an annualized 6.1% after fees, compared with 10.8% for the S&P 500. One of the authors of that paper, Ilia Dichev, of Emory University, says that performance is worse than it appears because hedge-fund investors tend to chase returns more than most investors. Chasing returns is a bad strategy because you tend to buy high and sell low. In the case of hedge-fund investors, it has had the effect of cutting that 6.1% return in half, says Dichev. Another concern for investors is that many funds disappear—either because of illegal activities or because they make big bets on bad strategies, lose most of their value and liquidate, often paying investors pennies on the dollar. In 2005, when investors were sending hedge funds billions in new assets, 10% of them liquidated. And then there are the fees. The standard rate is “2 and 20,” which means a fund charges an investor 2% of assets annually, plus 20% of any gains. That puts a damper on investors’ returns really quickly.

Conclusion for PFSI and our clients…
So? We won't be investing in hedge funds anytime soon… They lack our investment strategy requirements for transparency and liquidity, not to mention the extraordinary fees. And, we’re not big on making bets with your (or our) money. The one bet our investment strategy makes is that the long-term trend of the markets is up over time – history has shown that to be a solid bet. We know the ride isn’t smooth – normal economic cycles prevail and external forces can have sudden impacts. But, that is why we have the short-term and medium-term portfolios, choosing only to make even that one bet on money that won’t be needed for one to two economic cycles.

2011 Year-End Checklist Released

We are pleased to forward to you the annual PFSI Year-End Planning Checklist!  We have approximately 2 1/2 months to take advantage of planning opportunities to assist you in achieving your overall financial goals.

The tumultuous markets make ongoing rebalancing even more important than in less volatile periods; and, these economic swings often offer tax harvesting opportunities to offset gains (current year and future years). Additionally, the checklist provides a host of other timely financial considerations. Even 30 minutes spent on this should be time well spent.