Improve your understanding of hedge funds

Date: Tuesday, March 20, 2007
Author: ContraCostaTimes

Q: I'd like to learn more about hedge funds - how are they structured?

A The notoriety of the hedge fund has increased markedly during the past five years.

Once the reserved domain of extremely wealthy individuals and financial institutions, hedge funds have recently become available to both affluent and moderate-income investors.

The funds are structured as partnerships and are not regulated by the government or securities industry.

Although classified as an "alternative asset" for asset allocation purposes, some funds may have the same strategies as the common mutual fund and offer no reduction in risk to an investment portfolio.

Hedge funds may have hundreds of different investment strategies, which may vary from extremely conservative to speculation on steroids.

A few examples of the different investment styles are: a fund holding a stock position in one company while selling short the stock of a weaker company in the same sector, a fund making investments based on the fluctuations of foreign currencies, a fund focusing on a specific sector of the economy, and a fund making large investments in interest rate sensitive investments.

One key feature of hedge funds that is typically unavailable to mutual funds is the use of leverage. The hedge fund will borrow money from a bank or brokerage firm as a percentage of the dollars in the fund, often in an eight to one ratio.

This allows the fund to purchase significant stakes in companies or sectors. It is this leverage that may allow a hedge fund to provide outsized investment returns. It may also lead to the collapse of the fund and loss of substantial capital, as occurred to Long Term Capital Management several years ago. Fees and costs associated with hedge funds can be an obstacle to total returns for an investor.

As with any managed account, there is a management fee. For hedge funds, it is often 1 percent to 2 percent of the assets per year. Hedge funds in most cases will participate in the gains of the fund by taking 20 percent to 40 percent of profits generated above the base investment.

Smaller investors often participate in a fund of hedge funds. This structure adds an additional layer of management fee. I feel that the costs involved with hedge fund ownership will usually make it difficult for an investor to achieve a reasonable rate of return relative to the investment risk that many hedge funds take.

Q How have you adjusted your investments with the changing real estate market?

A For the past two years I have been paying particular attention to economic data related to the real estate sector of our economy.

As a percentage of our gross domestic product, the amount of resources devoted to real estate has risen substantially in the past five years, primarily driven by the Federal Reserve Bank lowering its base rate to 1 percent and subsequently raising the rate to 5.25 percent during the past 18 months.

Home builders took advantage of the rates and strong demand to build an oversupply of homes. I read recently that we are experiencing the greatest number of vacant homes since the Great Depression.

Another item of interest was when noted real estate investor Sam Zell sold his commercial properties in 2006. I question whether the buyer has a better sense of timing and valuation.

I have adjusted my clients' portfolios by increasing the allocation to fixed income investments, increasing the amount invested in stocks that are less sensitive to a slower economy (consumer staples and health care), decreasing investments in retail sector, and holding a much higher percentage of cash equivalents.

This week's statistic of the lowest number of new homes sold in January since 1994 has only reinforced my conservative view of the investment environment.