The truth, of course, is somewhere in between—an important point to make, now that hedge funds are coming to Main Street. A growing number of funds are looking to issue shares to the public through IPOs. Baskets of funds are being marketed through “fund of funds” vehicles. And hedge-fund techniques are increasingly being offered by more-traditional asset managers; one form is called a 130/30 equity fund—i.e., a vehicle that can borrow money to leverage its bullish equity positions to 130 percent of its capital and, at the same time, sell stock that it does not own (short) to the tune of 30 percent based on its bearish calls.
Are hedge funds a smart bet for average retail investors? Maybe. In addition to their potentially high returns, hedge funds can be portfolio diversifiers, since they have access to a broad range of investment instruments. They are able to “leverage” to amplify the upside of their purchases, they can “short” not only stocks but also bonds and commodities to protect capital in the event of market downturns, and they can access sophisticated “derivative” products that can offer a more refined manner to express an investment view.
Yet Main Street investors should note the following before investing:
Hedge funds are not cheap. The fees typically amount to 2 percent of the invested capital and 20 percent of returns. This compares with a total of 0.5 to 1.5 percent for most actively managed mutual funds, and even less for index funds.
Not all hedge funds are created equal. For each superstar manager, there are hundreds of mediocre ones. Access to good managers is constrained by high minimums and wait lists of investors.
Most hedge funds expect you to " lock up " your money. By ensuring that investor capital is locked up for several quarters or years, hedge-fund managers are able to invest on the basis of potentially profitable long-term views. But this also limits the ability of investors to withdraw their capital.
Hedge funds have inherently fragile structures. As investors were reminded in the last few weeks, they are similar to thoroughbred horses: even those that have done extremely well in the past can suddenly stumble—and with disastrous consequences—when the investment terrain becomes unusually bumpy. This is particularly the case for managers who use large amounts of borrowed money and who do not diversify sufficiently. What is an upside in good times can be a heavy burden when the going gets tough.
Good hedge-fund managers typically face the challenge of becoming good business managers. Hedge funds make it to the top because of investment expertise, but as that success is recognized it attracts more money. The managers must figure out how to cope with the trio of size, client interactions and talent management, and more than a few have tripped up.
Given these considerations, as well as the current global market instability, it is not surprising that politicians and regulators in many countries are debating whether and how they should influence the way hedge funds are sold to Main Street. The deliberations are gaining steam as hedge funds’ cousins in the alternative investment industry—namely private-equity firms—are being floated on major exchanges.
Investors should hope for a wise government response, but not depend on it. No matter how well intentioned regulators are, they simply cannot keep up with the financial sophistication and alchemy that are inherent in hedge funds. Instead, investors should rely on three basic rules:
First, in addition to viewing it as a long-term commitment that is subject to both tremendous upside and a calamity, the money invested in hedge funds should not exceed an amount that can be made up elsewhere over time.
Second, investors should seek a diversified basket of hedge funds rather than trust their money to a single manager, no matter how exceptionally well the fund has performed in the past.
Third, remember that, due to the high fee structure, investors start the relationship with hedge funds in negative territory. Accordingly, there is no point in ending up with just “average” managers. Investors should have conviction in their ability to find the superior managers. And they should recognize that judging managers is a tricky business. An error of omission is better than ending up with the wrong hedge fund.
