Part 1: Should we use hedge funds?

Every couple years I review the efficacy of hedge funds to examine whether it makes sense for my clients. Every year I end up with the same conclusion: No. My objective is not to find hot funds that deliver out-of-this-world performance but rather I’m searching for asset classes with returns that move out of phase with the majority of other asset classes in my portfolios. In so doing, I lower the volatility of the portfolio and increase risk- adjusted returns for clients.

Here is the upside in using hedge funds:

• (supposedly) the brightest minds in fund management.
• Fund managers have their own life savings at risk in the fund, so they’re motivated to earn positive returns.
• Fund managers may take more risk than mutual fund managers (usually).
• Fund managers may short markets, use options, and other esoteric devices to deliver returns.
• There are perhaps 6 main categories of hedge funds. Each has varying degrees of correlation with stock markets.

• They charge too much. A fund usually charges 1%/yr + 10% of all gains. Ouch.
• Funds of Funds are collections of hedge funds. These typically charge a similar fee, leaving the client paying 2%/yr +20% of the gains. Add my fee to the pile and the investment will have a very strong headwind to overcome.
• Poor transparency. Because the fund managers want to protect their secret sauce (their method of investing), they do not offer great visibility into what clients hold in their investment.
• Lock Ups. Frequently your money is locked up for a year or more. You cannot get it back no matter what until the lock up is done.
• Risk: If fund managers have a bad month/quarter/year, they may be forced to take on highly leveraged positions in order to bet big to recapture their losses (increasing risk).This happens when the window of fund redemption is coming up (the time period when investors are permitted to withdraw their money). When managers ratchet up their bet, the fund can implode at lightning speed- causing investors to lose most or all of their money.
• High minimum investment amounts. Having a minimum investment of $100K or more is not uncommon. I want to have access to a fund that can be used with all my clients. That means I need a fund with minimum investment asset size of $10K.
• Need to be an Accredited Investor (AI). An AI is a couple with either a net worth of $1M, or annual earnings of $300K+. An AI may also be a person with $1M in net worth or $200K in earnings. Many of my clients fit that description, but not all.

We have ruled out funds of funds, but am considering a hedge fund that does not suffer from most of the downside points listed above. Specifically, we are considering including a fund that is a managed futures fund (1 of the 6 main categories of hedge fund) in my new model portfolio. Managed Futures are an asset class that is not well correlated with the other asset classes. They are an asset class that may make money in any economic environment. Managed Futures involve using options on commodities, stock markets and currency markets.

For some perspective on the growth of the hedge fund industry, consider that the industry has grown 50-fold from 1990 to last year – to a value of $2T. Industry insiders are now estimating that assets will drop 30-40% and that we will see a wash-out of up to half the funds. There are currently around 7000 hedge funds.

The reason for the sell-off in hedge funds this year is likely tied to several key issues. First, the credit squeeze hit hedge funds hard because of their use of leverage. To leverage means you are borrowing on credit. If credit becomes expensive or non-existent, this adversely impacts you if you are reliant on it. To some, the credit squeeze as served to point out that many hedge funds are just highly leveraged funds with mediocre returns that are amplified by the leverage. Point taken.