How To Invest In Hedge Funds – Part Two
The previous post outlined the main characteristics of hedge funds and how they have grown to become mainstream investment products.
After reading it, you might think that, if they are good enough for pension schemes and university endowments, they could be good for you.
Perhaps, but there are several risks to be weighed before doing anything.
First, hedge funds apply more complicated investment strategies than unit trusts and mutual funds. These include relative value, market-neutral, merger arbitrage, equity long- short, convertible arbitrage, event-driven, etc.
Even without understanding these terms, the complexity is evident.
Complexity isn’t bad
Not that complexity is bad. Rather, it makes the sources of performance harder to understand, compared with retail vehicles.
That makes it difficult to evaluate the risks and, if you can’t do that, how can you judge what the return should be?
Secondly, most hedge funds are managed by boutiques.
The average hedge-fund management company employs fewer than 30 people and manages about $40 million in assets.
Even Bridgewater Associates, the largest, has only $133 billion in assets, even though they employ a staff of about 1,700.
That compares with a headcount of 13,900 and assets of $6.3 trillion at BlackRock, the world’s biggest mainstream manager.
Or the $1.4 trillion managed by 1,650 people at Legal & General Investment Management, the UK’s largest.
Their small size enables hedge funds to be nimble and, therefore, better able to profit from changeable markets. But it also makes them more vulnerable as businesses.
For 2018, up to early-December, Eurekahedge, a research firm, reported that 477 funds were wound up, worldwide, compared with 463 new launches.
Overall, about a third of all new hedge funds fail within three years of launching.
With many fewer positions held than in retail funds, the concentrated portfolios of most hedge funds involve greater risk because a loss on any one investment has a bigger impact.
Though it could be said that fewer holdings mean the manager should know more about each. And we all know knowledge is the best antidote to risk.
Maybe, but the operative word here is “should”. How can you trust a manager to do what they should? Besides, try as they may, they cannot know everything.
Beg, steal or borrow
Fourth, there is leverage risk when a fund borrows in order to buy more securities. Borrowing can be beneficial.
If you have a mortgage on your property in a rising market, you know that already. For £80,000, you can buy £100,000 of value.
If that rises 20%, you make 25% on your investment. However, a 20% drop in value means a 25%, or £20,000, loss on your bet.
That hurts, but it’s nothing compared to the leverage risk in some hedge funds, where your £80,000 investment may be ‘geared’ two, five, even 10 times over.
At that level, a 10% gain in the underlying assets will double your money. Equally, you’ll be wiped out by a 10% loss.
Sell, sell, sell
Fifth, there is a liquidity problem.
Usually, retail fund investors can redeem their commitment on any weekday. For hedge funds, dealing mostly happens monthly, sometimes even less frequently.
Many also impose a lock-up, a period following investment when no redemptions are allowed, or only on payment of a fee.
Lock-ups may last two or three years. Finally, there is key-man risk.
Most hedge funds have just one or two portfolio managers.
What happens to performance if such a key person falls ill, gets divorced, even dies?
Besides, is there anyone with power to stop the manager, who’s likely to be the main shareholder of the firm, from wilfully breaching the fund’s investment guidelines?
This is the most common cause of failure.
Then, there’s cost. Competition from new funds and pressure from investors have reduced fees steeply in the past decade.
But hedge funds still charge much more than retail funds.
Although their average total expenses are impossible to calculate accurately, the average annual management charge is about 1.6%.
That is only one part of costs, yet it’s similar to the average total of all expenses for UK equity funds.
Likewise, other costs (auditors, directors, transaction charges, custody, valuation, etc) are higher than for retail funds. There is also a performance incentive.
That could be as much as 30% of the return, and it’s unlikely to be less than 10%.
There is another money hurdle. Retail funds set low commitment levels, often just a few pounds. However, hedge funds are limited to knowledgeable investors.
There being no accepted measure for that knowledge, a high minimum commitment is set instead.
The lowest is usually about $100,000, but $1 million is more common, and levels many times that are not unknown.
This side of the law
With such costs, risks, and barriers, are these funds worth the effort?
The previous post noted the advent of hedge funds in the investor-friendly UCITS format over the past decade or so.
Such tight regulation has only reduced fees and minimum commitments marginally.
But it has boosted transparency by applying high standards for reports to investors. This allows them to see and understand the risks and fees much better.
The UCITS regulations have also transformed accountability by requiring fund managers to have a base in the EU, with a minimum level of capital and locally-resident directors.
So, if something goes wrong, the investor doesn’t have to rely on distant and unfamiliar island courts for recourse or compensation.
Being free from investment restrictions and complicated, not all hedge funds can be adapted to UCITS rules, but a wide range of strategies is available.
With a little help from my friends
In any case, prospective fund investors should never go it alone unless they are experienced or professional.
All funds, not just hedge funds, are complicated to some degree and involve risks unrelated to what’s happening in the markets.
They are also numerous – about 10,000 hedge funds, plus 1,500 UCITS hedge funds – making evaluation and selection a near-impossible task for the amateur with limited access to the tools of the trade.
So, you should sign up with a good professional investment adviser, one who takes careful note of your requirements, your personal circumstances, and your appetite for risk.
Their services aren’t free of charge, but should pay off handsomely in terms of your savings goals – and you can get a good night’s sleep.
Paul Connolly
Paul Connolly has been a journalist for more than 20 years, as a reporter and editor for Argus Media, Reuters, The Times, Associated Newspapers and The Guardian. He has covered Islamic Finance for Reuters in the 1990s. Paul has since helped launch three newspapers, as well as reported from Tokyo, Los Angeles and Stockholm.
