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Hedge Funds: Growing Up?

Date: Thursday, June 5, 2008
Author: Jeremy Hetherington-Gore, Investorsoffshore.com

IMPORTANT WARNING: The contents of this report have been compiled in good faith by Investorsoffshore.com to provide assistance to investors, but do not constitute investment advice or recommendations. Investors should not rely upon the information given in order to choose types or routes of investment but should make their own independent enquiries before making choices. Investorsoffshore.com has taken reasonable care in researching and presenting the information herein but makes no representations as to its accuracy and accepts no liability for actions taken or not taken as a result.

After the annus miserabilis of 2007, which saw such world-scale disasters for the hedge-fund sector as the demise of Amaranth, hedge funds have delivered a fairly unremarkable performance so far in 2008, seem to have avoided any major difficulties, and are even thought to have played a leading role in stabilizing financial markets in the aftermath of the US sub-prime melt-down.

Amaranth led to a renewed push by regulators for stringent control of hedge funds, but once again the industry seems to have remained free of the controls that would probably sap its life-blood, and has taken significant steps towards improved self-regulation, with the development of a unified set of global 'best practice' standards.

Responding to the Amaranth debacle while on a European trip in late September, US Securities and Exchange Commissioner Paul Atkins agreed that no new regulations on hedge funds are needed. He said the SEC would continue its probe into whether Amaranth misled investors, but that rules to prevent a widespread systematic failure in the market had worked. "It looked like the system worked" with the broker "getting nervous about exposure and taking steps to ensure it did not grow," Atkins told reporters in Brussels.

As a group, hedge funds are continuing to deserve their reputation as a stable store of value. They gained 10.4% in 2007, nearly double the 5.49% return of the S&P 500 Total Return Index, according to year-end data compiled by hedge fund performance tracker Barclay Hedge, and year-to-date in 2008 have posted a loss of 1.40%, outperforming the S&P 500, MSCI World Equity, and FTSE 100 indices which have year-to-date returns of -5.03%, -5.03%, and -5.72%, respectively, according to the Greenwich Global Hedge Fund Index.

“Rebounding global credit and equity markets are evident in the returns of hedge fund managers this month,” noted Margaret Gilbert, GGHFI Managing Director in May. “Seven of the Greenwich sub-strategy index groups now exhibit positive year-to-date performance.”

Hedge funds have outperformed US stock markets in six of the past 11 years, three of which were in the bear market of 2000 to 2002, according to Sol Waksman, founder and president of Barclay Hedge. “In up years, stocks usually outperform the hedge fund industry as a whole, since hedge funds include both long and short strategies, whereas stock indexes are always 100% long," he noted in announcing the annual performance figures of the Barclay Hedge Fund Index, which tracks more than 6,500 hedge funds, fund of hedge funds, and managed futures programs.

According to HedgeFund.net, total hedge fund assets now stand at USD2.8 trillion, although they fell slightly in Q1 2008, with new hedge fund investments of USD53 billion more than offset by portfolio losses of USD93 billion.

Ernst & Young’s 2007 Global Hedge Fund Survey notes that finding, hiring and retaining the "right" people remains the key theme in attempting to deal the challenges facing the sector.

According to Ernst & Young, three key trends also stand out. Firstly, institutionalization of the hedge fund industry continues, both in terms of the way hedge fund managers organize their own operations and in terms of the investor base. Secondly hedge funds are diversifying into such areas as private equity and real estate. Thirdly, in terms of asset flows, the big are continuing to get bigger; it is estimated that around 5% of the total hedge fund managers manage 80% of the global hedge fund assets.

Ernst & Young welcomed the recent development of industry best practice standards which aim to address areas of concern such as disclosure, valuation, risk management, fund governance and shareholder conduct. Michael Ferguson, E&Y Asset Management Leader observed that: “The trends and developments we see in the hedge fund industry are indicative of a maturing industry."

So what's the truth of it? Do a few stable months mean that the industry has grown up? Have we seen the last of the good times of 20-40% returns? Are hedge funds heroes or villains?

Well, it's a lot easier to ask the questions than it is to answer them; and it is not even safe to try. What we can do, though, is to point to some of the basic features of hedge funds, which won't change overnight, and suggest some precautions to take before jumping head first into (or clambering expensively out of) what is a very complex and diverse investment sector.

What is a hedge fund?

From the amount of speculation and debate that has surrounded hedge fund investment in recent times, you could be forgiven for thinking that hedge funds were a relatively new development in the investment world. However, you would be wrong.

The first fund to be dubbed a 'hedge' fund was the A.W. Jones Group in 1949. The fund derived its nickname from its strategy of taking long and short positions in the stock of companies (a strategy which continues to be central to many hedge fund managers, and which will be explained in greater detail in the next section). This meant that it could hedge against macro-economic factors, while at the same time benefiting from the individual performance of specific companies.

Hedge funds offer the potential for attractive returns, and are a lot more nimble than traditional mutual funds or other investment structures, which makes them an especially suitable option in volatile or falling markets. Until recently, they required high minimum investments (many still do), and until very recently, were only allowed to accept 'accredited', or 'qualified' investors.

It has only been in the last ten to fifteen years that the industry has really taken off. According to estimates, in 1990 there were as few as 300 hedge funds in existence. However, by the year 2000, this number had multiplied to over 3,000 funds controlling around $400 billion. By 2005, hedge fund assets had more than doubled, with estimates placing the size of the industry at more than 8,000 active hedge funds.

Total assets managed by single manager hedge funds rose to more than $1.3 trillion in 2005, up from $1 trillion in 2004, according to research by Hedge Fund Manager Magazine. Meanwhile, assets held by funds of hedge funds, which allocate investors' money across a basket of single hedge funds, stood at $709 billion.

The United States accounted for the largest proportion of hedge fund assets at 58% of the total, with Europe accounting for 24%. Whilst Asia is expected to be the region where future hedge fund inflows will be highest, at present the area only accounts for about 5% of total assets.

Investors' appetite continued in 2006. Tremont Capital Management's Asset Flow Report for the second quarter of 2006 showed a $38.3 billion net inflow across all investment styles to a total of $954 billion, positive net inflows being seen across all hedge fund strategies measured.

The report suggests that the hedge fund industry is continuing to attract assets at a remarkable rate. "Investors are opportunistically diversifying their portfolios," stated Robert I. Schulman, Chief Executive Officer of Tremont Capital Management Inc. "Money is flowing into hedge funds generally, while within the industry investors are adjusting their portfolios to take advantage of the changing opportunity set," he added.

Are regulators a good thing or a bad thing for hedge funds?

The special position with regard to the regulatory authorities in most countries has meant that marketing of hedge funds to the general public has been severely restricted, and the authorities have tended to leave the funds alone, to make or lose money at will. But a number of factors are forcing the regulators to take a greater interest in hedge funds, including the sheer size of the industry, the pressure to allow retail sales, and the growing volume of institutional investment into hedge funds.

The SEC attempted to tighten registration rules for hedge funds in 2005 by changing the definition of a "client" under the Investment Act of 1940 so that hedge funds managing more than $30 million in assets with more than 15 clients would be obliged to register as investment advisers.

Previously, hedge funds could skirt the registration rule because they counted each fund under their managedeadline for US hedge funds to register is just about to expire, and a senior SEC official revealed that hedge funds, particularly those considered by the regulator to be high risk, could expect regular inspections from compliance officers. Hedge funds whose businesses are deemed high risk would face inspections at least once every three years, while low risk hedge funds which registered with the SEC might face inspections at random.

Between 700 and 800 hedge funds were expected to have registered with the SEC, including more than 100 hedge funds based outside United States, by the time that the new rules were expected to come into force in early 2006.

After a series of legal see-saws, however, Christopher Cox, chairman of the United States Securities and Exchange Commission, announced in August, 2006, that the SEC would not seek to appeal a court decision which overturned the regulator's registration rule.

In June 2006, a three-judge panel of the US Court of Appeals for the District of Columbia Circuit unanimously struck down the SEC's hedge fund adviser registration rules under the Investment Advisers Act, in the case Phillip Goldstein, et al. v. Securities and Exchange Commission.

Based on advice from the SEC's Solicitor and General Counsel, Cox said in a statement that it would be "futile" for the Commission to appeal against the decision since the ruling was based on multiple grounds and was unanimous.

Instead, Cox explained that the SEC had changed its tack to concentrate on "moving aggressively" on an agenda of rulemaking and staff guidance to address the legal consequences from the invalidation of the rule. Some of these rules may be issued as early as this week.

"Among the significant new proposals will be a new anti-fraud rule under the Investment Advisers Act that would have the effect of 'looking through' a hedge fund to its investors," Cox stated.

"This would reverse the side-effect of the Goldstein decision that the anti-fraud provisions of the Act apply only to 'clients' as the court interpreted that term, and not to investors in the hedge fund. At my direction, Commission staff are also considering whether we should increase the minimum asset and income requirements for individuals who invest in hedge funds."

Cox continued that staff guidance can be expected to address the grandfathering, transition and other miscellaneous relief necessitated by the vacating of the rule.

"This will help to eliminate disincentives for voluntary registration, and enable hedge fund advisers who are already registered under the rule to remain registered," he explained.

Cox also stressed that hedge funds remain subject to SEC regulations and enforcement under the antifraud, civil liability, and other provisions of the federal securities laws.

"The SEC will continue to vigorously enforce the federal securities laws against hedge funds and hedge fund advisers who violate those laws. Hedge funds are not, should not be, and will not be unregulated," he warned.

The UK's financial regulator, the FSA, says that while the risk posed by hedge funds to the overall stability of the financial system is low, their growing holdings of illiquid assets may nevertheless present a danger that markets could be destabilised at a time of future crisis.

In its Financial Risk Outlook report for 2006, the FSA noted that although there are now several large multi-billion hedge funds, none of these comes to close to the size of Long Term Capital Management, which imploded spectacularly in 1998 sparking fears of a collapse in the US banking system.

Nonetheless, the FSA went on to observe that hedge funds appear to be increasing their investments in a range of asset classes which are "inherently less liquid than conventional assets, or whose liquidity is more likely to be reduced in times of market stress".

This could contribute to further volatility in times of an economic shock or other events causing panic in the markets, the FSA warned.

The authority also cautioned that conflicts of interest may arise when hedge fund managers are trying to value particularly complex instruments, leading to a temptation to over-state the value of assets, especially as assets under management are one of the key criteria governing fund managers' performance fees.

In 'Old Europe', the financial authorities view hedge funds as on a par with nuclear waste. Jaime Caruana, Chairman of the Basel Committee on Banking Supervision, told Reuters that more transparency is needed in the hedge fund industry given that many banks now have exposure to the lightly regulated industry.

"Efforts to improve the level and the quality of the information disclosed are necessary in order to allow investors and market participants to properly assess the risks they are assuming," Caruana stated.

He urged banking institutions to exercise caution in their dealings with hedge funds, which have come under the spotlight of many regulating institutions because of their unaccountability, despite controlling billions of dollars in assets in the world's markets.

"As banking supervisors, we should emphasize that banking organisations measure and control their exposures to hedge funds accurately," he stated.

While Caruana acknowledged that hedge funds play a positive role by improving the efficiency of markets, he cautioned that there are two sides to the coin because hedge funds often buy risky assets from regulated entities such as banks, which must set aside reserves to cope with any potential loss.

"Hedge funds ... are active players in risk transfer markets, where risks are transferred from credit institutions to other investors. There could be a risk of hedge funds engaging in regulatory arbitrage, leading finally to the financing of high risk profile borrowers," he observed.

Edgar Meister, chairman of the Banking Supervision Committee of the European Central Bank (ECB), has warned that the rapidly growing hedge fund industry has the power to destabilise European financial markets, and hinted that the potential risks posed by hedge fund trading activity warrant closer scrutiny.

Presenting the ECB's annual report on banking stability, Mr Meister noted that hedge funds can "seriously affect" financial stability through their largest creditors and counterparties - in other words, banks.

He went on to add that the "opacity" of hedge funds affects banks' ability to "aggregate their exposure to hedge funds," meaning that "monitoring" of the situation may be necessary where EU banks are concerned.

Mr Meister's words join a growing chorus from many regulators that hedge funds now wield too much power over the workings of financial markets. Jochen Sanio, head of German financial supervisor BaFin, has repeatedly warned that hedge funds "pose a big threat" to financial stability, while the International Organization of Securities Commissions (IOSCO), the global securities markets regulator, is drafting new rules aimed at controlling the increasingly influential $1 trillion hedge fund industry.

It isn't only Europe that worries, however. The Ontario Securities Commission is considering whether to tighten up provincial securities laws to prevent retail investors from gaining exposure to hedge funds in the wake of the Portus affair.

According to a report in the National Post, the OSC is examining the possibility of removing a regulatory exemption which allows hedge funds to sell to retail investors using principal-protected notes, or PPNs.

PPNs guarantee the investor's principal whilst also passing on any returns made by the underlying hedge fund. However, using something called the 'bank-debt exemption,' large banks or financial institutions can issue debt without filing a prospectus. This exemption also means that PPNs aren't subject to accredited-investor rules, which stipulate that hedge funds must only sell to high-net-worth investors with appropriate investment experience.

Commenting on the possible rule change, OSC vice-chairman Paul Moore told the National Post that: "We're very much aware that this would be a dramatic, but perhaps appropriate, step."

However, he added that: "We just have a concern that the bank-debt exception was never designed to allow hedge funds to be sold."

It is alleged that the Toronto-based hedge fund Portus Alternative Asset Management, which has left some 26,000 investors out of pocket following its collapse in 2006, used a PPN guarantee by the French banking group Societe General.

The industry doesn't agree with the regulators

The Alternative Investment Management Association (AIMA), the leading global hedge fund and alternative investment industry association, issued a response to 'Hedge funds: A discussion of risk and regulatory engagement,' the consultation paper issued by the UK Financial Services Authority.

AIMA’s response to the FSA papers, which were issued in June 2005, was prepared by the largest working group of members that AIMA has ever assembled to work on any regulatory consultation.

AIMA stated that it welcomes the FSA’s several acknowledgements of the benefits that hedge funds bring to financial markets and has also noted comments made by the FSA’s executive in recent weeks, referring to appreciation of hedge funds’ increasing importance and contribution to dynamic marketplaces and to the UK as the centre of hedge fund management in Europe.

However, the association said that it does not share the FSA’s perception of undue risk likely to be caused to markets by hedge funds, either singly or in multiples; in AIMA’s view, no evidence has been offered to suggest that hedge fund managers are likely to cause any more disruption to the market than other players.

"As in most years, a number of hedge funds may have suffered reversals in market performance and there has been a steady attrition of unsuccessful funds. However, in a free market, this is not a sign of ill-health in the market as a whole," it added.

AIMA also refuted claims that there is a higher level of fraud within the hedge fund industry than elsewhere, noting that the UK has, to date, had a clear record with regards to hedge fund fraud.

"AIMA rejects the suggestion that standards of systems and controls, compliance and risk management are somehow lower among hedge fund managers than other, more highly regulated firms: many specialist firms regard themselves as having ‘leap-frogged’ more traditional providers into next-generation systems and investment techniques, partly because of superior profitability and partly because of the lack of ‘legacy’ systems/issues," the association noted.

AIMA has welcomed the establishment of the FSA’s ‘centre of hedge fund expertise’, which is tasked with monitoring the activities of the largest hedge funds operating in the London markets. However, it qualified its support by observing that size alone is not a sufficient criterion for enhanced supervision, suggesting that both small and large hedge fund managers may run strategies that could be deemed as "high risk."

AIMA also disagreed that new ‘permissions’ for hedge fund management and/or prime brokerage are necessary or desirable.

"If there are to be changes, AIMA would prefer that industry participants be required to notify the FSA when commencing such activities," the association commented.

On valuation issues, AIMA does not believe that regulatory action alone is the best way forward, and it called for an industry-led, together with internationally-coordinated, initiative towards greater standardisation.

"AIMA broadly accepts that some form of ‘code of conduct’ might be a positive step but suggests that this should evolve from an industry initiative," the association said.

AIMA proposed that its own Sound Practices Guides might be expanded and updated with the involvement and endorsement of the FSA.

"The industry is likely to accept principles-based practices," it concluded.

Faced with so many threats of regulatory action, the industry finally started to get its act together in 2007, when 14 of the leading hedge funds, based mainly in London, established The Hedge Fund Standards Board (HFSB) in order to develop hedge fund best practice standards and monitor them.

When the US President’s Working Group on Financial Markets published its report on best practices for hedge fund managers and investors in April, 2008, they were welcomed by Sir Andrew Large, chairman of the HFSB:

“There is much common ground with the best practice standards for managers we published earlier this year. Our fundamental aims are the same and we both share a similar approach to addressing issues such as valuation, risk management and disclosure."

“We also welcome the principles and practices set out by the Investors’ Committee since the commitment of investors is so important to enforcing best practice."

“The HFSB looks forward to working with our colleagues in the US on developing harmonisation of international practice.”

The Working Group's best practices for the asset managers call on hedge funds to adopt comprehensive best practices in all aspects of their business, including the critical areas of disclosure, valuation of assets, risk management, business operations, compliance and conflicts of interest.

The best practices for investors include a Fiduciary's Guide and an Investor's Guide. The Fiduciary's Guide provides recommendations to individuals charged with evaluating the appropriateness of hedge funds as a component of an investment portfolio.

The Investor's Guide provides recommendations to those charged with executing and administering a hedge fund program once a hedge fund has been added to the investment portfolio.

Both best practices documents recommend innovative and far-reaching practices that exceed existing industry standards. The recommendations complement each other, by encouraging both types of market participants to hold the other more accountable.

Also in April, 2008, AIMA and the Washington-based Managed Funds Association announced that they are entering into an alliance that will allow the two organizations to work together more closely and to collaborate on key industry initiatives.

In making the joint announcement, Richard H. Baker, MFA President and CEO, and Florence Lombard, AIMA CEO, stated that: “MFA and AIMA will develop a framework for increased cooperation on issues of common interest such as the adoption of a global, principles-based regulatory system which will unify our members across jurisdictions and foster industry-wide compliance with the highest levels of sound business practices and integrity.”

Initially, MFA and AIMA will develop information exchange, participate on each others’ Boards, discuss the development of shared initiatives, and collaborate on educational seminars.

Christopher Fawcett, AIMA Chairman, explained that: “AIMA and MFA are seeking closer cooperation on issues of mutual interest and our aim is to facilitate communication among our members that will promote a unified approach to issues that impact our businesses and our ability to meet our investors’ needs."

"The international convergence of sound practices is the right way forward for the industry, and the demand and challenge now is for the industry to bring about convergence between the various standards proposed.”

Eric Vincent, MFA Chairman, added that: “Our members collectively represent the vast majority of alternative investment fund groups worldwide. We seek to establish a unified global industry voice, to avoid duplication of effort on common initiatives and to foster market disciplines and efficiencies for our members, counterparties and investors worldwide.”

The advantages of hedge funds

As previously mentioned, hedge funds are a lot more nimble than their mutual fund counterparts. This is because they are governed under a different (and much more permissive) regulatory system than traditional funds, which means that they are permitted to use instruments and strategies beyond the reach of conventional mutual funds, in order to secure the highest possible profit for investors and best manage investment risks.

Broadly speaking, hedge fund managers (or general partners, as they are more usually known), unlike mutual fund managers, are able to change the style or strategy used by the fund without prior investor consent, and the spectrum of styles available is enormous. The following (by no means exhaustive) list outlines some of the main strategies utilised by hedge fund managers, and the way in which each hopes to affect the performance of the fund:

  • Event-Driven. This strategy involves taking different positions in companies which are involved in takeovers, mergers, or acquisitions, or are in distress, in the hopes of predicting the effect that the event will have on their share prices. The Greenwich-Van Global Event Driven, Market Neutral Arbitrage and Equity Market Neutral Indices returned 1.06% (8.13% YTD), 0.80% (7.68% YTD) and 0.03% (4.47%YTD) in August, 2006, respectively.
  • Global International. Investing either in established markets, or in more risky emerging economies. For August, 2006, the Greenwich-Van Global Income, Emerging Markets and Multi-strategy indices returned 1.14% (5.86% YTD), 0.91% (10.17% YTD) and 0.38% (6.38% YTD), respectively.
  • Global Macro. Seeks to benefit from global macro-economic changes and developments.
  • Sector. Investing in a specific sector, for example financial services, real estate, or technology and communications.
  • Long/Short. Taking a long position in a stock is what most traditional investors and mutual fund managers do - they predict that the value of the stock will rise. However, in a hedge fund, alternative financial instruments can be used. Shorting involves finding overvalued companies, and selling borrowed stock in them in the hopes of buying it back later at a lower price. Greenwich Van reported that the Long/Short Equity Group returned 1.43% in August, 2006 (6.79% YTD) as managers were helped by gains in most traditional equity benchmarks. Greenwich-Van’s Global Value, Aggressive Growth, Opportunistic and Short Selling Indices returned 1.72% (7.24 YTD), 1.50% (5.56% YTD), 1.05% (7.11% YTD) and -1.65% (+2.30% YTD), respectively.
  • Market Neutral. This involves taking both long and short positions in the same market or sector in order to offset risk - basically like betting on two sides of the same coin. The Greenwich Van Market Neutral Group yielded 0.75% in August 2006, (7.28% YTD). The arbitrage strategies continue to deliver strong returns in 2006. Improving credit spreads, a strengthening bond market, and slightly higher single stock volatility created a very good environment for convertible traders in August, the company said.
  • Fund of Funds. Funds of funds (FOFs) don't invest directly in market instruments, but take positions in selected funds, meaning that they can use a mixture of strategies, or specialize in just one.

There are many more strategies open to hedge fund managers, of course, and they are able to chop and change as market conditions dictate.

Hedge fund managers are usually highly skilled and experienced, as the system and rates of compensation for successful managers tend to be very attractive. Although a successful mutual fund manager may well be able to afford a weekend home with a pool on his earnings, a successful hedge fund manager is more likely to have a weekend home with an island. Or so the saying goes.

General partners are compensated in a very different way to mutual fund managers, as the majority of their fee is based on how well the fund performs. Generally, their fee is something like 1-2% of the total assets of the fund, plus a performance or incentive based fee. Some funds also stipulate a 'watermark' or 'hurdle' which the fund must outperform in order for the manager to profit. Hedge fund managers are also usually more heavily invested in the funds they run themselves, and so have more of a vested interest in ensuring that the fund performs exceptionally. Mutual fund managers usually base their fees on the volume of assets managed, regardless of performance.

Disadvantages of hedge funds

Which brings us neatly onto the possible disadvantages of hedge fund investment. Although the way in which hedge fund managers are compensated can, and in the majority of cases does, encourage excellence and shrewdness, it can also sometimes encourage greater risk-taking in order to ensure that the fund is productive.

The relative lack of regulation in the hedge fund sector of most countries is something of a double-edged sword, and the ability to invest in 'volatile' sectors or instruments can sometimes present a risk. The occasional demise of very large hedge funds, such as Long Term Capital Management and now Amaranth has enhanced the public perception of this risk.

However, many experts feel that the risky nature of hedge fund investment has been overstated. Although managers are generally somewhat secretive about investment strategies, and reporting to investors does not take place as frequently as with conventional investment vehicles, there is no fundamental and necessary reason why hedge funds should present more of a danger. On the contrary, academic research conducted over the past few years has shown that hedge funds have had higher historical returns than traditional stock and bond investments of similar risk.

In reality, less than 5% of the world's hedge funds utilise 'risky' investment strategies such as global macro or emerging markets. Most hedge funds only use derivatives for offsetting market risk, and many do not use leverage at all. (Leverage is the extent to which an investor, business, or fund is using borrowed money to finance transactions).

Be that as it may, securities regulators have always been keen that inexperienced domestic investors are not exposed to any more risk than is strictly necessary, and one area in which they do impose strict regulation for hedge funds is in the barriers they place in the way of investors themselves.

As well as passing muster in terms of investment knowledge and experience, a potential investor must be prepared to stump up a sizeable minimum investment, and must be able to demonstrate a substantial net worth. This is in part to deter the unwary, and in part because as hedge funds are limited by the authorities in the number of investors that they can accept, a large sum is needed from each investor in order to make the venture worthwhile.

The criteria for accredited, or qualified investors have been defined as follows in America, and it is safe to assume that similarly stringent definitions exist in other countries, although consultation with an independent financial advisor will clarify exactly what the situation is in your country of residence:

  • Must have an individual net worth, or joint net worth with spouse exceeding $1 million, or;
  • Must have had an individual income of $200,000 (or joint income of $300,000) in the two years preceding, and have a reasonable expectation of a similar level of income in the current year, or;
  • Must be an institution, employee benefit plan, partnership, or foundation which meets the accredited investor criteria.

At this point you may be wondering why, if all but the super-rich are excluded from investing in hedge funds, we have bothered to write a primer on hedge fund investing. Well, as the 'mass affluent' group continues to grow, so does the popularity of hedge funds, a trend which has meant that service providers are beginning to see the possibilities inherent in the sector, and are looking at ways in which to offer the increased profitability found in hedge funds to the individual investor. In the next section, we will be looking at the investment opportunities open to those unfortunately excluded from the Forbes list, but not quite in the poorhouse!

The days of online deep discount hedge fund brokers and hedge fund supermarkets are still some way off. Despite, or perhaps because of, growing investor curiosity, regulators are still cautious, and will allow hedge fund providers and managers opportunities to attract more mainstream investors only as they prove their trustworthiness.

There are however a growing number of hedge fund portals and one-stop sites for investors, advisors, and the industry alike, and they tend to offer a variety of services, including the provision of news, performance data, topical articles, and sometimes databases of contact information for service providers. As a result of still stringent regulation in the majority of countries, in order to access sensitive information (such as contact details or performance data) it is usually necessary to register.

For the moment at least, there are basically three ways to access hedge fund investment opportunities:

  • Invest directly. This is only really an option for accredited investors (using the definition described above) and institutional investors due to fairly prohibitive investment criteria, although a number of countries are beginning to introduce rules for retail level hedge fund investment.
  • Invest through an investment management company, wealth manager, or independent financial advisor. Probably a more suitable option for the mass affluent investor, as an outside financial consultant is more likely to be 'in the loop'. (Because of the restrictions on advertising, a great deal of hedge fund information is circulated by word of mouth, or on designated news sites, so contacts are important. Investing in this way also offers an added advantage (well not really an advantage, more of a necessity actually); an advisor will be able to take you through the appropriate options for your country of residence, personal circumstances, and net worth.
  • Invest through a third party firm. As interest in hedge funds grows, a number of financial service providers are offering opportunities to invest in what are essentially funds of hedge funds, thus spreading both the perceived risk and the cost of minimum investment.

The United Kingdom's financial regulator, the Financial Services Authority (FSA), is one of those that has been toying with retail distribution for hedge funds. It announced in February, 2008, that a Consultation Paper confirming the policy of introducing retail-oriented Funds of Alternative Investment Funds (FAIFs) into the FSA’s regulatory regime had been published.

Dan Waters, FSA Director Retail Policy and Themes and Asset Management Sector Leader, commented that:

"Permitting consumers access to a wider range of innovative investment strategies through authorised onshore vehicles will allow more choice and a better opportunity for risk diversification, while maintaining consumer protection through our proportionate rules on the operation of the product. We aim to make the final adjustments to the new regime before the end of the year, including the additional areas on which we are consulting today."

He continued: "As we have previously stated, there are a number of difficult tax issues involved in the operation of onshore FAIFs regime. Following constructive discussions with the Treasury on tax issues we welcome the publication today of their tax framework, setting out a new elective regime which aims to allow FAIFs to operate competitively within the UK retail market.”

To avoid any regulatory regime being used to gain unintended tax advantages the FSA also proposes to include a ‘genuine diversity of ownership’ condition in its rules. This condition is similar to those proposed in the Property Authorised Investment Funds discussion paper issued by the Treasury in December 2007.

The new consultation will close on May 22nd, 2008. The FSA will then finalise the draft rules in light of the responses, and publish a Policy Statement giving feedback towards the end of the year. This will set out the finalised rules for FAIFs as whole and the date on which they will come into effect.

Are hedge funds still the best play in town?

Although there are doubts about the construction of the metrics quoted on hedge funds, for instance because of what is called 'survivorship bias', which tends to measure only surviving hedge funds and ignores those that closed, and there are concerns that 2005 saw the end of the hedge funds' glory days, the returns obtained by hedge funds have been superior to most market instruments over a long period of time.

Hedge funds do particularly well during market downturns. For instance, while the benchmark S&P 500 index lost 14%, 17.8% and 21.1% in 2000, 2001 and 2002, the Van Global Hedge Fund Index, which measures performance across approximately 5,800 funds, gained 8.4%, 6.3% and 0.1% over the same periods.

There is risk, of course. However, many experts feel that the risky nature of hedge fund investment has been overstated. Although managers are generally somewhat secretive about investment strategies, and reporting to investors does not take place as frequently as with conventional investment vehicles, there is no fundamental and necessary reason why hedge funds should present more of a danger. On the contrary, academic research conducted over the past few years has shown that hedge funds have had higher historical returns than traditional stock and bond investments of similar risk.

Funds of hedge funds, as the name suggests, offer diversification across a range of hedge funds at lower minimum investments. They are able to do this because they pool the resources of multiple investors - it has been estimated that to gain proper diversification, an individual investor would need to invest in at least 5-6 hedge funds, a feat which all but the very richest individual would find it difficult to achieve. Funds of funds can do just this because of their greater purchasing power. Typically, funds of funds will include a variety of asset classes such as equities, bonds, cash, alternative strategies, and real estate, but obviously the make-up varies considerably from product to product, and increasingly there are funds of hedge funds (FoHF).

Another, not inconsiderable advantage to investing in hedge funds in this way is that investors are able to take advantage of the expertise and resources of a number of industry professionals, as FoHF investment by necessity takes a multi-manager approach. FoHF investing may also provide access to hedge funds which would otherwise be closed to new money due to regulatory and capital restrictions.

Critics of this type of investing point to the likelihood of a higher fee structure in order to absorb both the management costs of the underlying hedge funds and of the FoHF itself, as a significant disadvantage. However, the costs involved although higher than with ordinary mutual fund investment, are unlikely to be doubled, as many fund of hedge funds providers have agreements with the hedge funds to reduce the amount of fees paid, a saving which is then passed on to the investor.

Hedge fund investment, although it appears to be slowly becoming more accessible, is never going to be the poor man's choice, and regulatory nervousness on the part of many authorities will mean that there is unlikely to be a headlong rush for the bandwagon. However, this is, in many ways, a good thing, as long experience (south sea bubbles, Dutch tulips, technology stocks, etc), has shown that a sudden rush of interest from the general public can often be too much of a good thing. Also, the vast majority of hedge funds, by their very nature, would lose a great deal of their nimbleness if they became over-subscribed.

However, the increasingly diverse opportunities within the sector, and the ever growing body of knowledge surrounding the subject mean that for a relatively wealthy and experienced investor in the right circumstances, hedge fund investment, or more realistically, investment in a fund of hedge funds, could be a financially exciting alternative.

If you do decide that this is the way forward for you, it is always strongly advisable to consult with a qualified financial professional before proceeding. Not only will they be able to help you choose the fund that is right for you, but they may well have access to information regarding performance and cost which is simply unavailable to lone individual investors.

Due diligence

Although due diligence is a must prior to each and every investment decision, for hedge funds it is doubly so, for all the reasons previously mentioned. If you choose to invest in a fund of funds, a lot, although not all, of the work will have been done for you, but there are still some basic issues to be addressed before you part with your hard-earned (or inherited!) cash. The following is not a comprehensive list, however, so here again, professional advice is necessary.

The Fund (Or Funds…)

  • Volatility - look at the fund's volatility over monthly (or weekly) periods if these figures are available. Also look at whether the annual return was generated evenly throughout the year, or whether it is the result of one or two large gains in specific periods.
  • Breadth - if possible, check whether the general partner turned an even result on all issues, or whether one lucky trade accounted for good results.
  • Repetition - is the investment process repeatable, or were good returns the result of dumb luck?
  • Strategy-specific risk - important if you are investing directly in just one hedge fund, but slightly less so if you choose to invest in a fund of hedge funds due to the greater diversification offered. Still, you should make sure you understand the particular risks inherent in each hedge fund manager's strategy.
  • Leverage - look at to what extent the fund uses leverage to make transactions, the fund's rationale for this device, and whether leverage has ever been revoked for any reason. Obviously, the extent to which a hedge fund uses borrowed money, and the rationale behind it, will affect the riskiness of the investment, so this is an important one.

The Key Personnel

  • Background - look into the general background of the hedge fund, including the division of responsibility, its formation and structure, fund terms and relationships, and possible conflicts of interest.
  • Manager profile - look into the background, qualifications, employment history and track record of the manager or managers.
  • Reporting - Ascertain who the custodian of the fund's assets is, and also who the prime broker is. (And beware of any fund or hedge fund which asks you to send funds directly to it - they should always go to the prime broker or custodial bank.)
  • Administration. Find out whether the hedge fund manager uses a third party administrator to calculate monthly returns, and ask for background on the fund, their calculation methods, where their data comes from, and what procedures they have in place for ensuring that the terms of the fund are being upheld. However, concentration on the terms of the fund is more crucial with mutual fund investing than hedge fund investing given the fact that hedge fund managers can change strategies at a moment's notice to fit market conditions
  • Other investors. Although to a certain extent, you will already be aware of the general profile of other hedge fund investors (i.e. middling to filthy rich!), ask for any information that is available on the breakdown of institutional vs. individual investors, average investment amounts, etc. It may give you a clearer idea of whether the particular fund, or fund of funds, is suitable for you.