Fund of Hedge Funds and Hedge Funds

The stock market is simply an amazing organization when it comes to creativity.  Take hedge funds for example, they're not exactly mutual funds, and they're not exchange traded funds either.  So what is a hedge fund?

Hedge Fund Definition

Technically, a hedge fund is defined as a private investment fund.  They are usually organized as limited partnerships, and often employ non-traditional investment strategies.  This means they often shy away from investment strategies that involve long-term buying and holding of securities in a portfolio.

Hedge funds have been around since the late 1940s.  In their early days, a hedge fund was used to reduce market risk, by selling short some stocks then buying others at that same time.  Today, some hedge funds don't even include stocks in their portfolio, so the investment instrument has certainly evolved over time.

Hedge Funds and Mutual Funds

Whenever the stock market is under performing, whispers of hedge funds start to be heard.  The word "hedging" itself implies taking a defensive position, or placing an insurance "bet" to balance against down markets.  The past decade has seen a pretty flat stock market, and a corresponding rise in interest in these funds.  It is estimated there are approximately 9,000 hedge funds managing roughly $1.3 trillion in assets for their clients.

Hedge Fund Performance

There are several published studies that indicate hedge funds will outperform their mutual fund counterparts in bear markets.  As is the case with any investment vehicle, you should understand the risks and rewards of the investment.  So let's review the differences between hedge funds and mutual funds.  Later on, we'll also examine a fund with a funny name:  a fund of hedge funds.

Hedge Funds versus Mutual Funds

Just like mutual funds, a hedge fund pools money from various investors in an effort to provide acceptable returns.  However, unlike mutual funds, most hedge funds are not registered with the Securities and Exchange Commission.  This means that hedge funds do not have to abide by the reporting requirements of the SEC, and that agency does not provide the investor with any degree of regulatory oversight.

As mentioned earlier, hedge funds are considered private investment vehicles, and are restricted to accredited investors with net worth in excess of $1 million, or an income in excess of $200,000 per year.   Qualified purchasers can also join hedge funds if they own at least $5,000,000 in qualified investments.

Hedge funds have a limited number of investors in the group, typically less than 500.  That's why they are organized into a limited partnership.  There is no limit on the fees these funds can charge, and many have generous performance incentives for the fund managers in addition to normal fund management fees.

Hedge Fund Management Fees

If successful, starting a hedge fund can be very rewarding for the fund's management team.  The hedge fund manager is sometimes referred to as a "general partner," and this position is responsible for making investment decisions that are aligned with the fund's overall strategy.

The normal payment arrangement for a fund manager is they receive one or both of the following:

• Management Fees - usually based on a percentage of the fund's assets.  Management fees are often in the range of 2% of assets.
• Performance Incentives - the payment of incentives is usually tied to a performance threshold, and based on a measure of the fund's profitability.  Incentives can be quite high for a profitable fund, and fees in excess of 20% are possible.

Investing in Hedge Funds

Hedge funds offer the investor less liquidity when compare to mutual funds.  Often there is a short window of opportunity to invest or close out a position; this timeframe can be quarterly or sometimes annually.  Hedge funds are not limited to a single class of investment such as stocks.  They can utilize investment instruments such as financial leverage, derivatives, short selling, commodities, and they can even take a large stock position in just a single company.

Fund of Hedge Fund

A fund of hedge funds closes some of the gaps between hedge funds and mutual funds.  Most of these funds have a lower minimum investment requirement; typically in the range of $25,000.  The idea behind a fund of hedge funds is to lower the risk of a single hedge fund by creating a portfolio, or fund, of hedge funds.

Some funds of hedge funds are registered with the SEC.  If the fund is registered, they are required to provide investors with a prospectus and file semi-annual reports; just like a mutual fund.  Unfortunately, a fund of funds can also carry with it an additional layer of management fees.  In addition to paying the embedded management fees mentioned above, an additional 1 to 2% of assets might be paid to the fund managers as well as added performance incentives.

Basics of Hedge Funds

The bulleted list below outlines some of the factors an investor needs to understand before deciding to invest in a hedge fund or a fund of hedge funds:

• Risk and Reward - In a perfect market there is a balance. If the rewards are high, then you can be sure that significant risk exists too.
• Asset Valuation - Since hedge funds can place money into investment vehicles such as derivatives, these assets are often hard to value accurately.  It's important to understand how these valuations are calculated by the fund.
• Fees - This has been discussed in our article on no load mutual funds, and the same applies here.  Management fees can have a significant impact on your total return on investment.  Hedge funds include both management fees and generous performance-based incentives.
• Redemption Policy - Liquidity can also be a problem with hedge funds.  You might get locked into a one-year term or have limited opportunity to enter and exit the fund.  Make sure you understand the fund's policy on exiting the investment.

Because of the way hedge funds, and a fund of hedge funds, can be structured, you should not expect to automatically get the same protections you would with mainstream investment offerings.  The SEC and other securities agencies may only have a limited ability to monitor the activities of the fund.  Do your research, and don't be afraid to ask questions.  Check out the track record of the fund manager, and be skeptical of inconsistent patterns.

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