With all their exclusiveness and hype, hedge funds are not doing all that well
The unregulated funds are free to take any risk they please
NEW YORK » Hedge funds seem so glamorous, but small investors who lack the money for their minimum investments and hefty management fees shouldn't shed a tear -- hedge funds' recent performance just doesn't look that stellar.
The funds have been in the news lately because of a June court decision that kept them outside the watch of Securities and Exchange Commission regulators. The funds remain basically unregulated and their reporting standards are loose, to say the least, but their returns for the year to date still appear to be unenviable.
As of June 20, a Diversified Hedge Fund Composite calculated by Merrill Lynch was up 3.42 percent for the year to date. The average U.S. equity long/short hedge fund was doing worse, down 0.45 percent.
That doesn't look too great at a time when nearly risk-free three-month Treasury bills are yielding near 5 percent.
"Average hedge funds, whatever that means, appear to be up in the 4 to 4.5 percent" range, said Phil Maisano, head of alternative investments of Mellon Asset Management.
There is no exact definition of a hedge fund. In general, hedge funds, like mutual funds, pool investors' money. Unlike mutual funds, they don't have liquidity requirements, they can place unlimited dollars in one investment, and there are no limits on conflicts of interest.
Hedge funds are free to take any risk that strikes their managers' fancy. They can sell stocks long or short, borrow massively to amplify a trade and conduct arbitrage, in which they buy and sell a security in different markets to profit from the difference between prices. "Hedge funds often take large risks on speculative strategies," according to Barron's Dictionary of Finance and Investment Terms.
The investments at Long-Term Capital Management, the hedge fund whose 1998 meltdown required a $3.6 billion private bailout, included bets on whether certain mergers would happen. It borrowed so much money for one deal that its leverage was 20-to-1, according to Roger Lowenstein's book on the fund, "When Genius Failed."
"You're picking up nickels in front of bulldozers," an outside money manager warned Long-Term's managers.
Hedge fund managers pitch investors by saying their bold risks will lead to outsized returns. That's why hedge fund managers often charge hefty fees -- 1 percent to 2 percent of assets plus 20 percent of returns is not unusual. The funds are almost always closed to everyone but accredited investors, a group that includes institutions with assets above $5 million, individuals with a net worth above $1 million or individuals whose income exceeded $200,000 in each of the two most recent years. "In reality, though, an investor needs much more than that," Barron's dictionary notes dryly.
These wealthy individuals and well-funded institutions often agree to lock-up periods of longer than a year when they buy a hedge fund. Once their (quite large) minimum investment is in the fund managers' hands, the investor can't get it back for the length of the lock-up period.
None of this has scared off investors: Hedge fund assets are estimated at $1.3 trillion, compared to $9.5 trillion managed by mutual funds.
Many subcategories of hedge funds do look like they're delivering higher returns than the wider market this year. For instance, the Dow Jones Distressed Securities Benchmark was up 6.6 percent through June 20, which looks much, much better than the Standard & Poor's 500, which was up 2.27 percent for the same period.
But the hedge funds' returns should be taken with an extra large grain of salt. Hedge funds are nowhere near as transparent as a single stock, a market index or a mutual fund.
Consider the following caveat in Merrill's "Hedge Fund Monitor":
"Hedge fund indices may not be fully representative of hedge fund returns. Not all hedge funds are in hedge fund indices. The number of funds in each strategy sub-index is relatively small. Some reasons for this non-inclusion are funds closed to investors that do not report their performance to public databases, funds with poor returns that stop reporting performance, and successfully incubated funds that enter databases with 'instant' track records with a very low level of historical assets."
The SEC says on its Web site that hedge funds invest in highly illiquid securities that may be difficult to value. "Moreover, many hedge funds give themselves significant discretion in valuing securities."