Hedge Funds For Dummies E-Book

Ann C. Logue

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch
• Veröffentlichungsjahr: 2011

Seitenzahl: 585

Beschreibung

If you want to diversify your portfolio and lower your risk exposure with hedge funds, here's what you should know: Hedge Funds For Dummies explains all the different types of funds, explores the pros and cons of funds as an investment, shows you how to find a good broker, and much more. Authored by Ann Logue, a financial writer and hedge fund specialist, this handy, friendly guide covers all the bases for investors of all levels. Whether you're just building your first portfolio or you've been investing for years, you'll find everything you need to know inside: * What a hedge fund is and what it does * How hedge funds are structured * Determining whether a hedge fund is right for your portfolio * Calculating investment risk and return * Short- and long-term tax issues * Developing a hedge fund investment strategy * Monitoring and profiting on macroeconomic trends * Evaluating fund performance * Evaluating hedge fund management If you're investing for the future, you definitely want to minimize your risk and maximize your returns. A balanced portfolio with hedge funds is one of the best ways to achieve that sort of balance. This book walks you step by step through the process of evaluating and choosing funds, incorporating them into your portfolio in the right amounts, and making sure they give you the returns you expect and deserve. You'll learn all the ins and outs of funds, including: * What kind of fees you should expect to pay * Picking a hedge fund advisor or broker * Fulfilling paperwork and purchasing requirements * Performing technical analysis and reading the data * How to withdraw funds and handle the taxes * Tracking fund performance yourself or through reporting services * Hedge fund strategies for smaller portfolios * Performing due diligence on funds that interest you This friendly, to-the-point resource includes information you can't do without, including sample portfolios that show you how to invest wisely. Hedge funds are an important part of every balanced portfolio, and this friendly guide tells how to use them to your best advantage. With important resources, vital information, and commonsense advice, Hedge Funds For Dummies is the perfect resource for every investor interested in hedge funds.

Leseprobe

Hedge Funds For Dummies®

by Ann C. Logue

Hedge Funds For Dummies®

Published byWiley Publishing, Inc.111 River St.Hoboken, NJ 07030-5774www.wiley.com

Copyright © 2007 by Wiley Publishing, Inc., Indianapolis, Indiana

Published by Wiley Publishing, Inc., Indianapolis, Indiana

Published simultaneously in Canada

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Library of Congress Control Number: 2006932689

ISBN-13: 978-0-470-04927-3

ISBN-10: 0-470-04927-8

Manufactured in the United States of America

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About the Author

Ann C. Logue is a freelance writer and consulting analyst. She has written for Barron’s, the New York Times, Newsweek Japan, Compliance Week, and the International Monetary Fund. She’s a lecturer at the Liautaud Graduate School of Business at the University of Illinois at Chicago. Her current career follows 12 years of experience as an investment analyst. She has a BA from Northwestern University, an MBA from the University of Chicago, and she holds the Chartered Financial Analyst designation.

Dedication

To Rik and Andrew, for their love and support.

Author’s Acknowledgments

So many wonderful people helped me with this book! I talked to many hedge fund managers and others in the investment business, including Cliff Asness, Catherine Cooper, Beth Cotner, Nancy Fallon-Houle, Marshall Greenwald, Steve Gregornik, Anil Joshi of NuFact, Russ Kuhns, Alecia Licata of the CFA Institute, Dan Orlow, Tino Sellitto, Lisa Springer, Ryan Tagal at Morningstar, Scott Takemoto, and Gary Tilkin and Kelly Quintanilla at Global Forex Trading. I also talked to a handful of other hedge fund managers who asked to remain anonymous; they know who they are, and I hope they also know how much I appreciate their help. The CFA Society of Chicago put on a great conference entitled “New Considerations in the Quest for Alpha”, which took place in the middle of writing this book and gave me some valuable insights. I’m grateful to the volunteers and presenters who made the day so productive for me.

I want to thank a few friends who helped give me direction on writing this and who pointed me to friends of theirs who work in the hedge-fund business. Bev Bennett, Lisa Duffy, Mary Richardson Graham, and Erik Sherman all were wonderful help. I also need to acknowledge Jennie Phipps, the proprietor of Freelance Success (www.freelancesuccess.com), one of the best resources out there for professional writers.

As for the mechanics of putting together the book, Natalie Harris, Stacy Kennedy, and Josh Dials of Wiley were fabulous to work with. Their patience and good humor got me through a tough schedule. Marcia Layton-Turner gets kudos for introducing me to her agent, Marilyn Allen, who became my agent and made the book possible.

Thanks, everyone!

Publisher’s Acknowledgments

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Contents

Title

Introduction

About This Book

Conventions Used in This Book

What You’re Not to Read

Foolish Assumptions

How This Book Is Organized

Icons Used in This Book

Where to Go from Here

Part I : What Is a Hedge Fund, Anyway?

Chapter 1: What People Talk About When They Talk About Hedge Funds

Defining Hedge Funds (Or Should I Say Explaining Hedge Funds?)

Surveying the History of Hedge Funds

Generating Alpha

Introducing Basic Types of Hedge Funds

Meeting the People in Your Hedge Fund Neighborhood

Paying Fees in a Hedge Fund

Chapter 2: Examining How Hedge Funds Are Structured

Exploring the Uneven Relationships between Fund Partners

Only Accredited or Qualified Investors Need Apply

Following the Cash Flow within a Hedge Fund

Fee, Fi, Fo, Cha Ching! Paying the Fees Associated with Hedge Funds

Dealing with the Hedge Fund Manager

Seeking Alternatives to Hedge Funds

Chapter 3: Not Just a Sleeping Aid: Analyzing SEC Registration

Getting to Know the SEC’s Stance on Registration and Regulation

Going Coastal: Avoiding the Registration Debate through Offshore Funds

Investing in a Fund without Registration

Chapter 4: How to Buy into a Hedge Fund

Using Consultants and Brokers

Marketing to and for Hedge Fund Managers

Investor, Come on Down: Pricing Funds

Purchasing Your Stake in the Fund

Signing Your Name on the Bottom Line

Part II : Determining Whether Hedge Funds Are Right for You

Chapter 5: Hedging through Research and Asset Selection

First Things First: Examining Your Asset Options

Kicking the Tires: Fundamental Research

How a Hedge Fund Puts Research Findings to Work

Chapter 6: Calculating Investment Risk and Return

Market Efficiency and You, the Hedge Fund Investor

Using the Modern (Markowitz) Portfolio Theory (MPT)

Discovering How Interest Rates Affect the Investment Climate

Investing on the Cutting Edge: Behavioral Finance

Chapter 7: You Want Your Money When? Balancing Time and Liquidity

Considering Your Cash Needs

Like Dollars through the Hourglass: Determining Your Time Horizon

Poring Over Your Principal Needs

Handling Liquidity After You Make Your Initial Investment

Chapter 8: Taxes, Responsibilities, and Other Investment Considerations

Taxing You, the Hedge Fund Investor (Hey, It’s Better than Death!)

Figuring Out Your Fiduciary Responsibility

Transparency in Hedge Funds: Rare but There

Practicing Socially Responsible Investing

Chapter 9: Fitting Hedge Funds into a Portfolio

Assaying Asset Allocations

Using Hedge Funds as an Asset Class

Viewing a Hedge Fund as an Overlay

Mixing and Matching Your Funds

Part III : Setting Up Your Hedge Fund Investment Strategy

Chapter 10: Buying Low, Selling High: Using Arbitrage in Hedge Funds

Putting Arbitrage to Good Use

Cracking Open the Arbitrageur’s Toolbox

Flipping through the Rolodex of Arbitrage Types

Chapter 11: Short-Selling, Leveraging, and Other Equity Strategies

Short-Selling versus Leveraging: A Brief Overview

Strutting in the Equity Style Show

Market Neutrality: Taking the Market out of Hedge-Fund Performance

Rebalancing a Portfolio

Long-Short Funds

Making Market Calls

Putting the Power of Leverage to Use

Chapter 12: Observing How Hedge Funds Profit from the Corporate Life Cycle

Examining the Corporate Structure (And How Hedge Funds Enter the Picture)

From Ventures to Vultures: Participating in Corporate Life Cycles

Chapter 13: Macro Funds: Looking for Global Trends

Fathoming Macroeconomics

Taking Special Issues for Macro Funds into Consideration

Widening or Narrowing Your Macro Scope

Chapter 14: But Will You Make Money? Evaluating Hedge-Fund Performance

Measuring a Hedge Fund’s Risk and Return

Benchmarks for Evaluating a Fund’s Risk and Return

Putting Risk and Return into Context with Academic Measures

Serving Yourself with a Reality Check on Hedge-Fund Returns

Hiring a Reporting Service to Track Hedge-Fund Performance

Part IV : Special Considerations Regarding Hedge Funds

Chapter 15: Hooking Onto Other Types of Hedge Funds

Multi-Strategy Funds: Pursuing a Range of Investment Strategies

Funds of Funds: Investing in a Variety of Hedge Funds

Hedge Funds by Any Other Name

Entering Mutual Funds That Hedge

Chapter 16: Using Hedge-Fund Strategies without Hedge Funds

A Diversified Portfolio Is a Hedged Portfolio

Exploring Your Expanding Asset Universe

Structuring a Hedge-Filled Portfolio

Utilizing Margin and Leverage in Your Accounts

Hedge Fund Strategies in Mutual Funds

Chapter 17: Hiring a Consultant to Help You with Hedge Funds

Who Consultants Work For

What Do Consultants Do (Besides Consult)?

Hunting for the Hedge-Fund Grail: A Qualified Consultant

Managing Conflicts of Interest

Compensating Consultants for Their Services

Hedge Funds Pay the Consultants, Too

Chapter 18: Doing Due Diligence on a Hedge Fund

Why Do Due Diligence?

Becoming Your Own Magnum, I.I.: Investment Investigator

What Are You Gonna Do When the Hedge Fund Does Due Diligence on YOU!

Knowing the Limits of Due Diligence

Part V : The Part of Tens

Chapter 19: Ten (Plus One) Big Myths about Hedge Funds

A Hedge Fund Is Like a Mutual Fund with Better Returns

Hedge Funds Are Asset Classes That Should Be in Diversified Portfolios

Alpha Is Real and Easy to Find

A Fund That Identifies an Exotic and Effective Strategy Is Set Forever

Hedge Funds Are Risky

Hedge Funds Hedge Risk

The Hedge-Fund Industry Is Secretive and Mysterious

The Hedge-Fund Industry Loves Exotic Securities

Hedge Funds Are Sure-Fire Ways to Make Money

Hedge Funds Are Only for the “Big Guys”

All Hedge Fund Managers Are Brilliant

Chapter 20: Ten Good Reasons to Invest in a Hedge Fund

Helping You Reduce Risk

Helping You Weather Market Conditions

Increasing Your Total Diversification

Increasing Your Absolute Return

Increasing Returns for Tax-Exempt Investors

Helping Smooth Out Returns

Giving You Access to Broad Asset Categories

Exploiting Market Inefficiencies Quickly

Fund Managers Tend to Be the Savviest Investors on the Street

Incentives for Hedge Fund Managers Are Aligned with Your Needs

Introduction

You’ve seen the headlines in the financial press. You’ve heard the rumors about mythical investment funds that make money no matter what happens in the market. And you want a part of that action.

I have to be upfront: Hedge funds aren’t newfangled mutual funds, and they aren’t for everyone. They’re private partnerships that pursue high finance. If you don’t mind a little risk, you can net some high returns for your portfolio. However, you have to meet strict limits put in place by the Securities and Exchange Commission — namely that you have a net worth of at least $1 million or an annual income of $200,000 ($300,000 with a spouse). Most hedge-fund investors are institutions, like pensions, foundations, and endowments; if you work for an institution, you definitely need to know about hedge funds. I also have to let you in on a little secret: Not all hedge fund mangers are performing financial alchemy. Many of the techniques they use are available to any investor who wants to increase return relative to the amount of risk taken.

Hedge Funds For Dummies tells you what you need to know, whether you want to research an investment in hedge funds for yourself or for a pension, an endowment, or a foundation. I also give you information about investment theories and practices that apply to other types of investments so you can expand your portfolio. Even if you decide that hedge funds aren’t for you, you can increase the return and reduce the risk in your portfolio by using some of the same techniques that hedge fund managers use. After all, not everything fund managers do requires a PhD in applied finance, and not everything in the world of investing is expensive, difficult, and inaccessible.

About This Book

First, let me tell you what this book is not: It is not a textbook, and it is not a guide for professional investors. You can find several of those books on the market already, and they are fabulous in their own right. But they can be dry, and they assume that readers have plenty of underlying knowledge.

This book is designed to be simple. It assumes that you don’t know much about hedge funds, but that you’re a smart person who needs or wants to know about them. I require no calculus or statistics prerequisite; I just give you straightforward explanations of what you need to know to understand how hedge funds are structured, the different investment styles that hedge fund managers use, and how you can check out a fund before you invest.

And if you still want to read the textbooks, I list a few in the Appendix.

Conventions Used in This Book

I’ll start with the basics. I put important words that I define in italic font. I often bold the key words of bulleted or numbered lists to bring the important ideas to your attention. And I place all Web addresses in monofont for easy access.

I’ve thrown some investment theory into this book. You don’t need to know this information to invest in hedge funds, but I think it’s helpful to know what people are thinking when they set up a portfolio. I also make an effort to introduce you to some technical terms that will come up in the investment world. I don’t want you to be caught short in a meeting where a fund manager talks about generating alpha through a multifactorial arbitrage model that includes behavioral parameters. Many hedge fund managers are MBAs or even PhDs, and two notorious ones have Nobel Prizes. Folks in the business really do talk this way! (To alert you to these topics, I often place them under Technical Stuff icons; see the section “Icons Used in This Book.”)

During printing of this book, some of the Web addresses may have broken across two lines of text. If you come across such an address, rest assured that I haven’t put in any extra characters (such as hyphens) to indicate the break. When using a broken Web address, type in exactly what you see on the page, pretending as though the line break doesn’t exist.

What You’re Not to Read

I include sidebars in the book that you don’t need to read in order to follow the chapter text. With that stated, though, I do encourage you to go back and read through the material when you have the time. Many of the sidebars contain practice examples that help you get a better idea of how some of the investment concepts work.

You can also skip the text marked with a Technical Stuff icon, but see the previous section for an explanation of why you may not want to skim over this material.

Foolish Assumptions

The format of this masterpiece requires me to make some assumptions about you, the reader. I assume that you’re someone who needs to know a lot about hedge funds in a short period of time. You may be a staff member or director at a large pension, foundation, or endowment fund, and you may need to invest in hedge funds in order to do your job well, even if you aren’t a financial person. I assume that you’re someone who has plenty of money to invest (whether it’s yours or not) and who could benefit from the risk-reduction strategies that many hedge funds use. Maybe you’ve inherited your money, earned it as an athlete or performer, gained it when you sold a company, or otherwise came into a nice portfolio without a strong investment background.

I also assume that you have some understanding of the basics of investing — that you know what mutual funds and brokerage accounts are, for example. If you don’t feel comfortable with the basic information, you should check out Investing For Dummies or Mutual Funds For Dummies, both by Eric Tyson. (Calculus and statistics may not be prerequisites, but that doesn’t mean I don’t have any!)

No matter your situation or motives, my goal is to give you information so that you can ask smart questions, do careful research, and handle your money in order to meet your goals.

And if you don’t have a lot of money, I want you to discover plenty of information from this book so that you’ll have it at the ready someday. For now, you can structure your portfolio to minimize risk and maximize return with the tools that I provide in this book. You can find more strategies than you may know.

How This Book Is Organized

Hedge Funds For Dummies is sorted into parts so that you can find what you need to know quickly. The following sections break down the structure of this book.

Part I: What Is a Hedge Fund, Anyway?

The first part describes what hedge funds are, explains how managers structure them, and gives you a little history on their development. It also covers the nuts and bolts of SEC regulation and the process of buying into a hedge fund. Go here for the basics.

Part II: Determining Whether Hedge Funds Are Right for You

In this part, I cover many investment considerations — including your time horizon, your liquidity needs, taxes, and other special needs you may have — in order to help you figure out if you should be in a hedge fund. If you decide against it, the information here may give you some ideas on other ways you can invest your money. All investors face a list of goals for their money as well as a series of constraints that they must meet. The art of investing is balancing your investment objectives with constraints so that your money works the way you need it to.

Part III: Setting Up Your Hedge Fund Investment Strategy

Part III is the fun part — an overview of the many different ways that a hedge fund manager can generate a big return while keeping investment risk under control. Fund managers can buy and sell, take big risks, or rely on arbitrage; become shareholder activists or trade anonymously; or speculate on interest rates, currencies, or pork bellies.

This part also covers ways you can evaluate a hedge fund’s risk-adjusted performance. You’ve probably heard of a handful of headline-grabbing hedge-fund scams, and you can find plenty of investors who have learned the hard way just how much risk their hedge funds had.

Part IV: Special Considerations Regarding Hedge Funds

Part IV covers some additional information that you need to know, including alternatives to hedge funds for smaller investors. It also tells you how to get help with your investment and how to check out the background of the fund and fund manager before you invest. My goal is to help you do the right thing with your money, and this section helps you make the decisions that will achieve this goal.

Part V: The Part of Tens

In this For Dummies-only part, you get to enjoy some top 10 lists. I present 10 reasons to invest in hedge funds, 10 reasons to avoid them, and 10 myths about the hedge-fund business. I also include an Appendix full of references so that you can get more information if you desire.

Icons Used in This Book

You’ll see five icons scattered around the margins of the text. Each icon points to information you should know or may find interesting about hedge funds. They go as follows:

This icon notes something you should keep in mind about hedge-fund investing. It may refer to something I’ve already covered in the book, or it may highlight something you need to know for future investing decisions.

Tip information tells you how to invest a little better, a little smarter, a little more efficiently. The information can help you ask better questions of your hedge fund manager or make smarter moves with your money.

I’ve included nothing in this book that can cause death or bodily harm, as far as I can figure out, but plenty of things in the world of hedge funds can cause you to make expensive mistakes. These points help you avoid big problems.

I put the boring (but sometimes helpful) academic stuff here. I even throw in a few equations. By reading this material, you get the detailed information behind the investment theories, some interesting trivia, or some background information.

Where to Go from Here

Well, open up the book and get going! Allow me to give you some ideas. You may want to start with Chapter 1 if you know nothing about hedge funds so you can get a good sense of what I’m talking about. If you need to set up your investment objectives, look at Chapters 7, 8, and 9. If you want to know what hedge fund managers are doing with your money, turn to Chapters 10 through 13. And if you’re about to buy into a hedge fund, go straight to Chapter 18 so that you can start your due diligence.

If you aren’t a big enough investor for hedge funds but hope to be some day, start with Chapters 5, 6, and 9 to discover more about structuring portfolios. Chapter 16 can help you meet your investment objectives as a small investor.

Part I

What Is a Hedge Fund, Anyway?

In this part . . .

Y ou read about hedge funds in the financial press. You hear about their ability to generate good returns in all market cycles. And you wonder — just what is this investment? In this part, you find out. Part I covers definitions and descriptions you hear in the hedge fund world, offers the basics on just how much regulatory oversight hedge funds have, and lets you know how to buy into a hedge fund.

Chapter 1

What People Talk About When They Talk About Hedge Funds

In This Chapter

Knowing the long and short of hedge funds

Discovering the history of hedge funds

Factoring a fund’s position on alpha into your investment decision

Distinguishing between absolute-return funds and directional funds

Acquainting yourself with the important hedge-fund players

Perusing the fee structure of hedge funds

Is a hedge fund a surefire way to expand your wealth or a scam that will surely rip you off? Is it a newfangled mutual fund or a scheme for raiding corporations and ripping off hard-working employees? You see hedge funds in the news all the time, but it’s hard to know exactly what they are. That’s because, at its essence, a hedge fund is a bit of a mystery. A hedge fund is a lightly regulated investment partnership that invests in a range of securities in an attempt to increase expected return while reducing risk. And that can mean just about anything.

Some of the smartest money managers on Wall Street have started their own hedge funds, attracted by the freedom to manage money as they see fit while raking in good money for themselves and their investors in the process. Hedge fund managers today take on the roles of risk managers, investment bankers, venture capitalists, and currency speculators, and they affect discussions in boardrooms at brokerage firms, corporations, and central banks all over the world.

In this chapter, I cover the basic vocabulary and structure of hedge funds. Having this knowledge helps you understand hedge funds so that you can figure out what you need to know in order to make the best decisions with your money. Also, I clarify what a hedge fund is and what it isn’t, which is important because you come across a lot of myth and misinformation out there. The information you find here serves as a springboard for the topics I introduce throughout the rest of the book, so get ready to dive in.

Defining Hedge Funds (Or Should I Say Explaining Hedge Funds?)

Here’s the first thing you should know about hedge funds: They have no clear identity or definition. In the investment world, “I run a hedge fund” has the same meaning as “I’m a consultant” in the rest of the business world. The speaker may be managing money and making millions, or she may want a socially acceptable reason for not having a real job. The person who really manages money may go about her business in any number of ways, from highly conservative investing to wildly aggressive risk taking. She may be beating the market handily, or she may be barely squeaking by.

I’m not trying to say that the term “hedge fund” means nothing. Here’s the short answer: A hedge fund is a lightly regulated investment partnership that uses a range of investment techniques and invests in a wide array of assets to generate a higher return for a given level of risk than what’s expected of normal investments. In many cases, but hardly all, hedge funds are managed to generate a consistent level of return, regardless of what the market does. Before I get to the longer, more complicated explanation of hedge funds, however, it helps to know exactly what hedging is.

Hedging: The heart of the hedge-fund matter

Hedging means reducing risk, which is what many hedge funds are designed to do. Maybe you’ve hedged a risky bet with a friend before by making a conservative bet on the side. But a hedge fund manager doesn’t reduce risk by investing in conservative assets. Although risk is usually a function of return (the higher the risk, the higher the return), a hedge fund manager has ways to reduce risk without cutting into investment income. She can look for ways to get rid of some risks while taking on others with an expected good return, often by using sophisticated techniques. For example, a fund manager can take stock-market risk out of the fund’s portfolio by selling stock index futures (see Chapter 5). Or she can increase her return from a relatively low-risk investment by borrowing money, known as leveraging (see Chapter 11). If you’re interested in investing in hedge funds, you need to know how the fund managers are making money.

Risk remains, no matter the hedge-fund strategy, however. Some hedge funds generate extraordinary returns for their investors, but some don’t. In 2005, the Credit Suisse/Tremont Hedge Fund Index — a leading measure of hedge-fund performance (www.hedgeindex.com/hedgeindex/en/default.aspx) — reported that the average hedge-fund return for the year was 7.61 percent. The NASDAQ Composite Index (www.nasdaq.com) returned only 1.37 percent for the same period, but the Morgan Stanley Capital International World Index (www.mscibarra.com) was up 10.02 percent. The amount of potential return makes hedge funds more than worthwhile in the minds of many accredited and qualified investors (see Chapter 2 for more on hedge-fund requirements).

In 2005, 9,000 hedge funds managed a total of $1 trillion dollars, according to Hedge Fund Research, a firm that tracks the hedge-fund industry (www.hedgefundresearch.com). In 2005, therefore, the average fund had $111 million in assets. Given the industry’s standard fee structure, in which managers charge at least 1 or 2 percent of assets (see Chapter 2), the typical fund generated $1.1 to $2.2 million on the year for the fund manager.

Return is a function of risk. The challenge for the hedge fund manager is to eliminate some risk while gaining return on investments — not a simple task, which is why hedge fund managers get paid handsomely if they succeed. (For more on risk and return, check out Chapter 6.)

Identifying hedge funds: The long explanation

Okay, I’ll go ahead and start covering the gory details of hedge funds. A hedge fund is a private partnership that operates with little to no SEC regulation (see Chapter 3). A hedge fund differs from so-called “real money” — traditional investment accounts like mutual funds, pensions, and endowments — because it has more freedom to pursue different investment strategies. In some cases, these unique strategies can lead to huge gains while the traditional market measures languish. The following sections dig deeper into the characteristics of hedge funds, as well as the bonuses that come with funds and the possibility of bias in the reported performances of funds.

Little to no regulatory oversight

Hedge funds don’t have to register with the U.S. Securities and Exchange Commission (SEC). The funds and their managers also aren’t required to register with the National Association of Securities Dealers (NASD) or the Commodity Futures Trading Commission, the major self-regulatory bodies in the investment business. However, many funds register with these bodies anyway, choosing to give investors peace of mind and many protections otherwise not afforded to them (not including protection from losing money, of course). Whether registered or not, hedge funds can’t commit fraud, engage in insider trading, or otherwise violate the laws of the land.

In order to stay free of the yoke of strict regulation, hedge funds agree to accept money only from accredited or qualified investors. Accredited investors are individuals with a net worth of at least $1 million or an annual income of $200,000 ($300,000 for a married couple; see Chapter 2 for more information). Qualified investors are individuals, trust accounts, or institutional funds with at least $5 million in investable assets.

The reason for the high-net-worth requirement is that regulators believe people with plenty of money generally understand investment risks and returns better than the average person, and accredited investors can afford to lose money if their investments don’t work out. In order to avoid the appearance of improper marketing to unqualified investors, hedge funds tend to stay away from Web sites, and some don’t even have listed telephone numbers. You have to prove your accredited status before you can see offering documents from a fund or find out more about a fund’s investment style.

Aggressive investment strategies

In order to post a higher return for a given level of risk than otherwise expected (see Chapter 6, which covers risk calculation in much detail), a hedge fund manager has to do things differently than a traditional money manager. This fact is where a hedge fund’s relative lack of regulatory oversight becomes important: A hedge fund manager has a broad array of investment techniques at his disposal that aren’t feasible for a tightly regulated investor.

Here are a few investment techniques that I cover in great detail in this book:

Short-selling (Chapter 11): Hedge fund managers buy securities that they think will go up in price. If they spot securities that are likely to go down in price, they borrow them from investors who own them and then sell the securities in an attempt to buy them back at lower prices in order to repay the loans.

Leverage(Chapter 11): Hedge funds borrow plenty of money in order to increase return — a technique that can also increase risk. The fund has to repay the loan, regardless of how the investment works out.

The use of leverage is a key difference between hedge funds and other types of investments. Most hedge funds rely on leverage to increase their returns relative to the amount of money that they have in their accounts. Because of the risk that comes with the strategy, funds often use leverage only for low-risk investment strategies in order to increase return without taking on undue risk.

The Buffet Line: Okay, so I made this one up. But hedge fund managers do have a wide range of investment options. They don’t have to lock in to stocks and bonds only. They buy and sell securities from around the world, invest in private deals, trade commodities, and speculate in derivatives. They have flexibility that traditional asset managers only dream about. (See Chapters 10 through 13 for more information on the many options.)

Manager bonuses for performance

Another factor that distinguishes a hedge fund from a mutual fund, individual account, or other type of investment portfolio is the fund manager’s compensation. Many hedge funds are structured under the so-called 2 and 20 arrangement, meaning that the fund manager receives an annual fee equal to 2 percent of the assets in the fund and an additional bonus equal to 20 percent of the year’s profits.

The performance fee is a key factor that separates hedge funds from other types of investments. U.S. Securities and Exchange Commission regulations forbid mutual funds, for example, from charging performance fees. You may find that the percentages differ from the 2 and 20 formula when you start investigating prospective funds, but the management fee plus bonus structure rarely changes.

The hedge fund manager receives a bonus only if the fund makes money. Many investors love that the fund manager’s fortunes are tied to theirs. The downside of this rule? After all the investors pay their fees, the hedge fund’s great performance relative to other investments may disappear. For information on fees and their effects on performance, see Chapters 2 and 4.

Biased performance data

What gets investors excited about hedge funds is that the funds seem to have fabulous performances at every turn, no matter what the market does. But the great numbers you see in the papers can be misleading.

Hedge funds are private investment partnerships with little to no regulatory oversight, which means that fund managers don’t have to report performance numbers to anyone other than their fund investors. Many hedge fund managers report their numbers to different analytical, consulting, and index firms, but they don’t have to. Naturally, the funds most likely to participate in outside performance measurement are the ones most likely to have good performance numbers to report — especially if the fund managers are looking to raise more money.

On the other end of the success spectrum, many hedge funds close shop when things aren’t going well. If a fund manager is disappointed about losing his performance bonus (see Chapter 2), he may just shut down the fund, return all his investors’ money, and move on to another fund or another project. Hedge Fund Research, a consulting firm that tracks the industry (www.hedgefundresearch.com), estimates that 11.4 percent of hedge funds closed in 2005. After a fund shuts down, it doesn’t report its data anymore (if it ever did); poorly performing funds are most likely to close, which means that measures of hedge-fund performance have a bias toward good numbers.

You have to do your homework when buying into a hedge fund. You can’t rely on a rating service, and you can’t rely on the SEC, as you can with a mutual fund or other registered investment. You have to ask a lot of tough questions about who the fund manager is, what he plans for the fund’s strategy, and who will be verifying the performance numbers. (Chapter 18 covers this process, called due diligence, in more detail.)

Pledging the secret society: Getting hedge fund information

Some hedge funds are very secretive, and for good reason: If other players in the market know how a fund is making its money, they’ll try to use the same techniques, and the unique opportunity for the front-running hedge fund may disappear. Hedge funds aren’t required to report their performance, disclose their holdings, or take questions from shareholders.

However, that doesn’t mean hedge fund managers refuse to tell you anything. A fund must prepare a partnership agreement or offering memorandum for prospective investors that explains the following:

The fund’s investment style

The fund’s structure

The fund manager’s background

A hedge fund should also undergo an annual audit of holdings and performance and give this report to all fund investors. (The fund manager may require you to sign a nondisclosure agreement as a condition of receiving the information, but the information should be made available nonetheless.) But the hedge fund manager doesn’t have to give you regular and detailed information, nor should you expect to receive it. (See Chapter 8 for more on transparency issues.)

Beware the hedge fund that gives investors no information or that refuses to agree to an annual audit — that’s a blueprint for fraud. See Chapter 18 for more information on doing your due diligence.

Surveying the History of Hedge Funds

Hedge funds haven’t been around forever, but they aren’t exactly new, either. Their fortunes have varied with those of the markets, and their structures have evolved with the development of modern financial-management theories and techniques.

Knowing the history of hedge funds will give you a sense of how the modern hedge fund market came to be. You’ll understand how some of the myths of funds originated and why some of the practices (like fee structure and secrecy) developed over time. And, the history is interesting. Isn’t that reason enough? In this section, I cover some of the highlights and lowlights that have come since the development of the first hedge fund in 1949.

Alfred Winslow Jones and the first hedge fund

Alfred Winslow Jones wrote a book in 1941 that examined the attitudes of residents of Akron, Ohio toward large corporations. The book, Life, Liberty, and Property: A Story of Conflict and a Measurement of Conflicting Rights, is still in print by the University of Akron Press. When it came out, the magazine Fortune reprinted sections of the book, and Jones eventually joined the magazine’s editorial staff. While at Fortune, he learned quite a bit about investing, and in 1949, he quit the magazine to form a money-managing firm, A.W. Jones & Co., which is still in business in New York.

At Fortune, Jones covered some of the developing theories in modern finance — especially the notion that markets were inherently unpredictable. He was determined to find a way to remove the risk from the market, and the way he found was to buy the shares of stocks expected to go up while selling short the stocks expected to go down. With this strategy, he could remove much of the risk of the market, and his fund would have steady performance year in and year out. I describe this style of investing, sometimes called long-short investing, in Chapter 11. And in a twist of fate, Fortune first used the term “hedge fund” to describe Jones’ fund in a 1966 article.

Alfred Winslow Jones had two other innovations for the modern hedge fund, both of which have overshadowed his investment style:

His analysis of the Investment Company Act of 1940: In the analysis, he stated that a private-partnership structure can remain unregistered as long as its investors are accredited.

His fee. He charged his investors 20 percent of the fund’s profits. More than 50 years later, few hedge fund managers still hedge the way that Jones did, but almost every manager copies his partnership structure and fee schedule.

1966 to 1972: Moving from hedging to speculating

After Alfred Winslow Jones developed a nice business collecting 20 percent of the profits from his partners by using his hedging strategy, other money managers wondered if they could also set up private partnerships and charge 20 percent while following different investment strategies. The answer? Yes. The name “hedge fund” stuck, but the emerging funds were more speculative than hedged. Hedging is the process of reducing risk. Speculating is the process of seeking a high return by taking on a greater-than-average amount of risk. Although hedging and speculating are opposing strategies, many hedge funds today use both.

The change in strategy took place partly because the stock market was really strong, so short-selling proved to be a losing game (see Chapter 11). Also, because the stock market was so strong, money managers could make a lot of money by borrowing and buying stock.

And then, in 1972, the bottom dropped out. A stock-market bubble that formed at the end of the 1960s finally and totally burst, leaving hedge fund managers with big losses. Some managers who had borrowed heavily (or leveraged; see Chapter 11) found themselves insolvent. Most of the newly formed hedge funds shut their doors, and the aggressive style of investing fell out of favor for about a decade.

George Soros, Julian Robertson, and hedge-fund infamy

George Soros, who co-founded the Quantum Fund with Jim Rogers, and Julian Robertson, who founded the Tiger Fund, are two legendary names in the hedge-fund business. They both formed their funds in the late 1960s to early 1970s go-go era, managed to hold on through the market collapse that took place in 1972, and then started posting spectacular profits in the 1980s.

Both funds followed a macro strategy, which means they looked to profit from big changes in the global macroeconomy (see Chapter 13). They took bets on changes in interest rates, exchange rates, economic development, and commodities prices. They also used options and futures (see Chapter 5) to improve their returns and manage their risks. (In 1988, George Soros published a book about his unconventional approach to investing, The Alchemy of Finance [Wiley].)

Both fund managers achieved icon status of sorts in the 1990s, and then both managers ran into trouble. Soros made huge profits by betting (and investing accordingly) that the currencies of several Asian countries were overvalued. He was right, but the resulting collapse of the currencies led to political unrest in Indonesia and Malaysia and turned Soros into a pariah. Julian Robertson believed that the huge increases in technology stocks were overdone in the 1990s, and he was proven right in 2000, but his performance suffered terribly until then. (Chapter 13 dives into these stories more deeply.)

The rise and fall of Long-Term Capital Management

One infamous hedge fund, Long-Term Capital Management, had spectacular performance year after year until it nearly caused a global financial meltdown in 1998. The history of this firm tells a tale of just how little hedging takes place at some of the biggest and best-performing hedge funds.

The 1960s and 1970s brought about huge changes in the way that people thought about finance and investing. Experts developed several new academic theories (you can read about them in Chapters 6 and 14). Some academics realized that they could earn more by managing money than they could by teaching students how to do it, so they quit their university jobs and started hedge funds.

In 1994, John Meriwether, an experienced bond trader at Solomon Brothers, joined with other traders and two professors, Robert Merton and Myron Scholes, to form a fund. The fund’s managers took advantage of relatively small differences in the prices of different bonds. Most of their trades were simple and low-risk, but they used a huge amount of borrowed money (known as leverage) to turn their simple trades into unusually large returns. In 1997, Merton and Scholes shared the Nobel Prize in Economics, giving their fund a highly academic aura. People thought the fund was filled with investors who had discovered an unusually low-risk way of generating unusually large returns.

In the summer of 1998, the Russian government defaulted on its bonds, which caused investors to panic and trade their European and Japanese bonds for U.S. government bonds. Long-Term Capital Management bet that the small differences in price between the U.S. bonds and the overseas bonds would disappear; instead, the concern over Russia’s problems led to large differences in price that steadily widened. The mistake made it difficult for Long-Term Capital Management’s managers to repay the large amounts of money that the fund had borrowed, which put pressure on the investors who had given the loans. The Federal Reserve Bank then organized a restructuring plan with the banks that Long-Term Capital Management dealt with in order to prevent a massive financial catastrophe. In total, Long-Term Capital Management lost $4.6 billion dollars.

The Yale Endowment: Paying institutional attention to hedge funds

The Yale University Endowment, which operates in the financial and trade press, has $15.2 billion under management as of press time, making it the second-largest college endowment in the world. Its success has driven most of the institutional interest in hedge funds, and institutional interest has created all the demand in the market. The performance of the Yale Endowment is considered a milestone.

It has long kept 25 percent of its assets in hedge funds, and in this avenue, it performs the best out of all the major university endowments. The fund’s manager, David Swensen, earned a doctorate in finance at Yale and worked on Wall Street before joining Yale’s staff in 1985. Once on board, he decided to diversify the university’s money into holdings other than stocks and bonds, adding investments in private equity, oil, timberland, and hedge funds.

Management members at other endowments and foundations have long looked at Yale’s performance with green-eyed envy. They’ve witnessed one of the richest colleges get richer, in part due to hedge-fund investing, and they want to do the same. By 2005, the National Association of College and University Business Officers reported that 8.7 percent of all college-endowment money was invested in hedge funds, up from 1.8 percent in 1996. And, in 2005, 21.7 percent of the money in endowments larger than $1 billion was invested in hedge funds.

Generating Alpha

Hedge fund managers all talk about alpha. Their goal is to generate alpha, because alpha is what makes them special. But what the heck is it? Unfortunately, alpha is one of those things that everyone in the business talks about but no one really explains.

Alpha is a term in the Modern (Markowitz) Portfolio Theory (MPT), which I explain in Chapter 6. The theory is a way of explaining how an investment generates its return. The equation used to describe the theory contains four terms:

The risk-free rate of return

The premium over the risk-free rate that you get for investing in the market

Beta

Alpha

Beta is the sensitivity of an investment to the market, and alpha is the return over and above the market rate that results from the manager’s skill or other factors. If a hedge fund hedges out all its market risk, its return comes entirely from alpha.

People aren’t always thinking of the Modern (Markowitz) Portfolio Theory when they use alpha. Instead, many people use it as shorthand for whatever a fund does that’s special. In basic terms, alpha is the value that the hedge fund manager adds.

In theory, alpha doesn’t exist, and if it does exist, it’s as likely to be negative (where the fund manager’s lack of skill hurts the fund’s return) as positive. In practice, some people can generate returns over and above what’s expected by the risk that they take, but it isn’t that common, and it isn’t easy to do.

Introducing Basic Types of Hedge Funds

Despite the ambiguities involved in describing hedge funds, which I outline in detail at the beginning of this chapter, you can sort them into two basic categories: absolute-return funds and directional funds. I look at the differences between the two in the following sections.

Because hedge funds are small, private partnerships, I can’t recommend any funds or fund families to you. And because hedge fund managers can use a wide range of strategies to meet their risk and return goals (see the chapters of Part III), I can’t tell you that any one strategy will be appropriate for any one type of investment. That’s the downside of being a sophisticated, accredited investor: You have to do a lot of work on your own!

Absolute-return funds

Sometimes called a “non-directional fund,” an absolute-return fund is designed to generate a steady return no matter what the market is doing. Alfred Winslow Jones managed his pioneering hedge fund with this goal, although the long-short strategy (see Chapter 11) that he used was just one of several methods that snagged him consistent returns (see the section “Alfred Winslow Jones and the first hedge fund”).

Although absolute-return funds are close to the true spirit of the original hedge fund, some consultants and fund managers prefer to stick with the label absolute-return fund rather than “hedge fund.” The thought is that hedge funds are too wild and aggressive, and absolute-return funds are designed to be slow and steady. In truth, the label is just a matter of personal preference.

An absolute-return strategy is most appropriate for a conservative investor who wants low risk and is willing to give up some return in exchange. (See Chapter 9 for more information on structuring your portfolio.) Hedge fund managers can use many different investment tools within an absolute-return strategy, a few of which I present in Part III of this book.

Some say that absolute-return funds generate a bond-like return, because like bonds, absolute-return funds have relatively steady but relatively low returns. The return target on an absolute-return fund is usually higher than the long-term rate of return on bonds, though. A typical absolute-return fund target is 8 percent to 10 percent, which is above the long-term rate of return on bonds and below the long-term rate of return on stock.

Directional funds

Directional funds are hedge funds that don’t hedge — at least not fully (see the section “Hedging: The heart of the hedge-fund matter” for more on hedging). Managers of directional funds maintain some exposure to the market, but they try to get higher-than-expected returns for the amount of risk that they take. Because directional funds maintain some exposure to the stock market, they’re said to have a stock-like return. A fund’s returns may not be steady from year to year, but they’re likely to be higher over the long run than the returns on an absolute-return fund.

Directional funds are the glamorous funds that grab headlines for posting double or triple returns compared to those of the stock market. The fund managers may not do much hedging, but they have the numbers that get potential investors excited about hedge funds.

A directional strategy is most appropriate for aggressive investors willing to take some risk in exchange for potentially higher returns. (See Chapter 9 for more information on structuring your portfolio.)

Meeting the People in Your Hedge Fund Neighborhood

Many different people work for, with, and around hedge funds. The following sections give you a little who’s who so you understand the roles of the people you may come into contact with and of people who play a large role in your hedge fund.

Managers: Hedging for you

The person who organizes the hedge fund and oversees its investment process is the fund manager — often called the portfolio manager or even PM for short. The fund manager may make all the investment decisions, handling all the trades and research himself, or he may opt to oversee a staff of people who give him advice. (See Chapter 2 for more information on hedge fund managers.) A fund manager who relies on other people to work his magic usually has two important types of employees:

Traders: The traders are the people who execute the buy-and-sell decisions. They sit in front of computer screens, connected to other traders all over the world, and they punch in commands and yell in the phones.

Traders need to act quickly as news events happen. They have to be alert to the information that comes across their screens, because they’re the people who make things happen with the fund.

Analysts: Traders operate in real time, seeing what’s happening in the market and reacting to all occurrences; analysts take a longer view of the world. They crunch the numbers that companies and governments report, ask the necessary questions, and make projections about the future value of securities.

Lawyers: Following the rules

Although hedge funds face little to no regulation, they have to follow a lot of rules in order to maintain that status. Hedge funds need lawyers to help them navigate the regulation exemptions and other compliance responsibilities they face (see Chapter 3), and hedge fund investors need lawyers to ensure that the partnership agreements are in order (see Chapter 2) and to assist with due diligence (see Chapter 18).

Consultants: Studying funds and advising investors

Because big dollars are involved, many hedge fund investors work closely with outside consultants to advise them on their investment decisions. Hedge fund managers also work with consultants — both to find accredited investors through marketing and to make sure that they’re meeting their investors’ needs. (For more information on working with a consultant, see Chapter 17.)

A consultant can take a fee from an investor or from a hedge fund, but not from both. That way, the consultant stays clear of any conflicts of interest.

Advising investors

A key role for consultants is helping investors make sound investment decisions. Staff members who oversee large institutional accounts — like pensions, foundations, or endowments — rely heavily on outside advisors to ensure that they act appropriately, because these types of accounts hinge on the best interests of those who benefit from the money. (See Chapters 8 and 10 for more on this responsibility.)

Consultants not only ensure that investors follow the law, but also advise investors on the proper structure of their portfolios in order to help them meet their investment objectives. A consultant analyzes how the investor divides the money among stocks, bonds, and other assets and then recommends alternative allocations that may result in less risk, higher return, or both (see Chapter 9 for more on asset allocation).

Monitoring performance

Investment consultants track the performance of their clients, of course, but they also build relationships with hedge fund managers and collect data on the risk, return, and investment styles of different funds and fund managers. They use the information they collect to advise their clients on investment alternatives. Because you can find only a few central repositories for hedge-fund performance information, and because hedge funds don’t have to make their return data public, this is an important service. (See Chapter 14 for more info on evaluating performance.)

Marketing fund managers

Many hedge funds are small organizations. In some cases, the fund managers work alone. These funds have a small number of investors, and they may not allow their investors to take money out for a year or two, so they don’t need to do constant marketing. It rarely makes sense for a hedge fund to have a dedicated marketing person on staff.

But that doesn’t mean hedge funds don’t need to find other investors. When the fund is new or when current investors want to withdraw their money, marketing becomes important. To help find new investors, many hedge funds work with consultants, who bring together investors looking for suitable hedge funds and hedge funds looking for suitable investors.

Paying Fees in a Hedge Fund

Hedge funds are expensive, for a variety of reasons. If a fund manager figures out a way to get an increased return for a given level of risk, he deserves to be paid for the value he creates. And, one reason hedge funds have become so popular is that money managers want to keep the money that they earn instead of getting bonuses only after they meet big corporate overhead. Face it — a good trader would rather keep his gains than share them with an overpaid CEO who doesn’t know a teenie from a tick. (Chapters 2 and 4 contain more information on paying fees, but here I cover the basics.)

A teenie is 1/16 of a dollar. A tick is a price change. If the next trade takes a security up in price, it’s an uptick; if it takes the security down, it’s a downtick. In the olden days, when everything traded in eighths or teenies, ticks were printed on strips of paper called ticker tape. If a person did something notable, like win a World Series or land on the moon, he or she would receive a parade, and everyone at the brokerage firms would open their windows and throw out their used ticker tape (hence, ticker-tape parade).

Almost all hedge fund managers receive two types of fees: management fees and performance fees. More than anything else, this business model, not the investment style, distinguishes hedge funds from other types of investments.

Managing management fees

A management fee is a fee that the fund manager receives each year for running the money in the fund. Usually set at 1 percent to 2 percent of assets in a fund, the management fee covers certain operating expenses, salaries for the fund manager and staff, and other costs of doing business. The fund pays other expenses in addition to the management fee, such as trading commissions and interest.

For example, say a hedge fund has $100,000,000 in assets. It charges a 2-percent management fee, which is $2,000,000. The fund has an additional $1,750,000 in trading expenses and interest. The fund investors have to pay fees from the assets whether the fund makes money or bombs.

If the fund’s management fee is too low, the fund manager won’t be able to run the business effectively or hire the necessary staff. If the fee is too high, the fund manager will make such a nice living that he or she will have little incentive to pursue a performance bonus.

Shelling out your percentage of performance fees

Most hedge funds take a percentage of the profits as a performance fee — also called the incentive fee or sometimes the carry. The industry standard is 20 percent, although some funds take a bigger cut and some take less. You need to read the offering documents you receive from a fund to find out what the fund charges and whether the fund’s potential performance justifies the fee.

If the fund loses money, the fund manager gets no performance fee. In most funds, the fund managers can’t collect performance fees after losing years until the funds’ assets return to their previous high levels, sometimes called the high-water marks. You can find a detailed explanation of how these fees work in Chapter 2.

The performance fee means that the fund manager’s incentives are closely aligned with those of the fund’s investors. As folks on Wall Street say, hedge fund managers eat what they kill. The big problem with the performance fee is that if a fund has a negative year, the fund manager has an incentive to close the fund and start over instead of losing the performance fee. And every fund will have a bad year once in a while.

In many cases, a hedge fund’s outstanding performance disappears after the performance fee hits the manager’s pocket. You may find that you’re paying a lot of money and dealing with many complications to be in a hedge fund when you could get the same net return through a different type of investment, like a mutual fund.