Traditionally, hedge funds have been to investing what Park Avenue is to real estate. But these vehicles for the rich are now becoming both more common and modestly more accessible.
Those changes may be timely because the stock market’s stunning swings recently may make these investments far more attractive. The reason: Although their returns lag behind other investments during good times, hedge funds–private investor partnerships that use complex trading and hedging strategies–significantly outperform the market when it declines.
When the Standard & Poor’s 500-stock index gained 17.5 percent in the second quarter of this year, for example, hedge funds gained just 7.1 percent, according to a hedge fund index constructed by Hedge Fund Research of Chicago.
But in the worst four quarters for stocks since 1990, the S&P 500 lost an average of 5.8 percent in each quarter, while hedge funds gained 1.4 percent, on average, each period.
In August, the most recent period for which Hedge Fund Research has figures, hedge funds rose an average of 0.41 percent, while the S&P 500 fell 5.6 percent.
Hedge funds, which follow dozens of investing styles, have been gaining popularity for a while. Perhaps hoping to protect their gains in the bull market, investors have pumped $40 billion into such funds in the last year, according to MAR/Hedge, an industry newsletter based in New York. That money increased the industry’s total assets under management by about 40 percent.
To be sure, hedge funds are generally open only to “sophisticated” investors, defined at a minimum as those with either $1 million in net worth or annual salaries for two years running of $200,000 for single people and $300,000 for married couples.
But a $1 million net worth–a measure that includes the value of a house–is becoming less rare. Three percent of the adult population–or about three million people–were millionaires in 1995, up from 2.5 percent in 1989, and the percentage has continued to climb, according to an analysis by Sanford C. Bernstein & Co.
“With this bull market running, many people have gotten very wealthy on paper,” said James R. Hedges IV, managing director of LJH Global Investments, a consulting firm in Naples, Fla., that specializes in hedge funds.
Indeed, Barry Barbash, director of the division of investment management at the Securities and Exchange Commission, said $1 million might no longer be a suitable determinant for investor sophistication. “It was a test that worked in 1980, but it deserves a look to see whether it ought to be increased,” he said.
For those on the border line of eligibility, entering a hedge fund may be getting easier.
One reason is the industry’s rapid expansion, from about 420 funds in 1990 to more than 3,000 today, according to Hedge Fund Research.
Hungry for capital, some of these new funds often accept far smaller minimum investments than the $488,000 average for all hedge funds.
Hedge funds are getting roomier, too. Federal rules previously limited fund membership to 100 investors, but a 1996 law raised the ceiling to 500. Although funds with 500 investors can admit only individuals with a minimum of $5 million in actual investments–not net worth–industry observers say they expect that a growing number of managers will have parallel funds with 100 investors. And the old eligibility rules still apply to those smaller funds.
Even if they fall short of those requirements, determined investors can find ways to infiltrate a fund. For example, federal law allows managers to give some slots to the otherwise ineligible, though that is rare in practice. Funds with 100 investors can have up to 35 non-accredited people, though the managers must provide them with the equivalent of a prospectus, a sometimes burdensome task.
Investors can also pool assets with family members in limited partnerships and thus gain entry to hedge funds that they could not join on their own. Although partnerships of unrelated investors can only invest in hedge funds if they have a wide range of other investment interests, family partnerships, because they are assumed to be engaged in estate planning, can invest in just a hedge fund.
Another tactic: Although investing taxable money offshore is not permitted under the tax laws, tax-exempt money doesn’t have that restriction. And offshore funds, of which there are at least several hundred, are not subject to the United States’ net worth requirements.
Of course, hedge funds have dangers. They are far less regulated than mutual funds, and their managers are free to use leverage and other risky techniques. And even if investors can obtain entry, they may want to think twice before tying up a large chunk of their wealth in a single hedge fund.
One alternative is a fund of funds, or a hedge fund that invests in other hedge funds. Besides providing diversification, funds of funds often have lower minimums than other funds do, although investors must pay an extra layer of fees, said Lois Peltz, managing editor of MAR/Hedge.
Investors should not despair if hedge funds’ doors are closed to them. Many mutual funds, like Heartland Small-Cap Contrarian, are mimicking hedge funds’ tactics.
HOW TO FIND A HEDGE FUND
Finding hedge funds is not easy. Such funds are subject to few disclosure rules and are covered only sporadically by the press. Below are some publications that specialize in hedge funds. Some of these guides are offered by investment consultants, who can be retained for fees averaging 1 percent of an investment to recommend funds and offer other help for these vehicles.
– The MAR/Hedge newsletter. Industry analyses and performance figures. Monthly, $445 a year, 212-213-6202.
– Hedge Fund News. Reports on new funds, the performance of an index of 18 leading hedge funds and industry developments. Quarterly, $175 a year, 212-371-5935.
– U.S. Offshore Funds Directory. Performance data for offshore hedge funds. Annual, $365, 212-371-5935.
– Hedge Fund Review. Market summaries and performance updates. Monthly, $200 a year, 212-857-4400.
– Van Hedge Fund Advisors. On-line reports on performance of a hedge fund index. Updated monthly, free, www.nashville.net/-vanhedge.
– HFR Journal. Round-table discussions with fund managers and articles on fund issues. Quarterly, $250 a year, 312-658-0957.
