Hedge Funds
09/15/07
A hedge fund is a private investment fund charging a performance fee and is typically marketed to only a limited range of qualified investors. In the United States, hedge funds are open to accredited investors only. Because of this restriction, they are usually exempt from any direct regulation by the SEC, NASD and other regulatory bodies. A hedge fund's activities are limited only by the contracts governing the particular fund, so they can follow complex investment strategies, being long or short assets and entering into futures, swaps and other derivative contracts. They often hedge their investments against adverse moves in equity and other markets, because a common objective is to generate returns that are not closely correlated to those of the broader financial markets. In most countries hedge funds are prohibited from marketing to non-accredited investors, unlike regulated retail investment funds such as mutual funds and pension funds, and are essentially private pools of managed assets. Because of this they have little incentive to release their private information to the public, and have acquired a corresponding reputation for secrecy. Typically, hedge funds charge 20% of gross returns as a performance fee, but again the range is wide, with highly regarded managers demanding higher fees. In particular, Steven Cohen's SAC Capital Partners charges a 50% incentive fee (but no management fee) and Jim Simons' Renaissance Technologies Corp. charged a 5% management fee and a 44% incentive fee in its flagship Medallion Fund before returning all investors' capital and running solely on its employees' money. Managers argue that performance fees help to align the interests of manager and investor better than flat fees that are payable even when performance is poor. However, performance fees have been criticized by many people including Warren Buffett for giving managers an incentive to take risk, possibly excessive risk, as opposed to high long-term returns. In an attempt to control these problems, fees are usually limited by high water marks and sometimes by hurdle rates.
Barclay Hedge Fund Index
The Barclay Hedge Fund Index is a measure of the average return of all hedge funds (excepting Funds of Funds) in the Barclay database. The index is simply the arithmetic average of the net returns of all the funds that have reported that month.
You can see that the performance of the Barclay Hedge Fund Index is not exactly stellar when compared to the annual performance of the S&P 500. It appears that the hottest investment idea since the bear market of 2000 – 2002 has already become a fad that is copied by too many operators to give anybody a real edge. Game over! If people carefully considered the structural deficiencies of hedge funds before investing, most would never invest.
Hedge funds are not designed to serve the best interests of investors.
They are designed to serve the best interests of hedge fund operators.
The glaring lack of transparency in hedge funds has recently become very obvious. Investors are at a significant information disadvantage compared with investors in other instruments. For example, the owner of a brokerage account can go online and see exactly what he or she owns and how much it is worth at any hour of the day, on any day of the year. Hedge fund investors cannot see how their capital is being allocated. Since they cannot see how their capital is positioned and how much debt leverage is used, there is no way for a hedge fund investor to gauge risk. The net result is a characteristic common to each and every hedge fund catastrophe. That is, the investor is the last to know.
After it was formed in 1994, Long Term Capital Management posted annual returns of more than 40 per cent until it collapsed in 1998. The fund employed
leverage that exceeded, at times,
30 times equity. With that much leverage, it should come as no surprise that $3.6 Billion of equity capital was wiped out in just five weeks, as soon as the
"convergence trade" went awry. As usual, the investors were the last to know.
Also, hedge funds have a misaligned incentive structure. The typical hedge fund charges at least a 1 per cent annual management fee plus 20 per cent of profits. This fee arrangement is aligned nicely to a hedge fund manager’s objective of getting rich. It is not aligned with investor goals such as long-term wealth accumulation or funding retirement. The misaligned incentive system opens up the potential for all sorts of investor abuse. Consider the asymmetrical consequences for a hedge fund manager that leverages investor capital to speculate on a 50/50 proposition. If it pays off, the manager gets a windfall equaling 20 per cent of profits while placing none of his own capital at risk. If it does not pay off, all the loss is borne by the investor. The incentive fee structure can also enrich hedge fund managers who ultimately lose all their investor’s capital. For example, many of the hedge funds that have collapsed in recent months generated high rates of return in prior years. Investors then paid fees of at least 20 per cent of annual profits to the managers. And now, post-blow-up, the investors are left with little or no capital left in their accounts. Last, hedge funds lack accountability. Because the industry is unregulated, any and all information promulgated by hedge funds should be viewed with caution. Without regulatory scrutiny and without disclosure about how returns are generated, investors have a right to be skeptical.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
