When average investors become aware of hedge funds, it’s usually because of trouble, such as the near collapse in 1998 of Long Term Capital or the multimillion-dollar loss incurred last year by the Art Institute of Chicago.
But as the bear market grinds on, hedge funds have an improved image because they are either making money or at least not losing it nearly as fast as everyone else.
Thus far this year, the Hennessee Hedge Fund Index, which tracks a broad spectrum of hedge funds, was down only 4.8 percent, only about a fourth of the loss of the broad market as measured by the Standard & Poor’s 500 index. Overall, 94 percent of the 3,000-some funds that New York-based Hennessee Hedge Fund Advisory Group tracks have beaten the S&P 500 this year.
When the rules for mutual funds were drawn up in 1940, regulators, still reeling from the financial chicanery of the 1929 crash, set up rules to protect investors.
They figured rich and sophisticated investors could take care of themselves and were allowed to invest in the then-fledgling hedge fund industry without government protection.
Only decades later did investors come to realize that the strategy known as hedging wasn’t necessarily as risky as it was perceived, and today more middle-income investors are trying to elbow their way into what was once considered a club only for the rich.
Over the last decade, the hedge fund industry has grown exponentially. It now stands at about $500 billion to $600 billion, up from only $20 billion in 1990.
Despite the new interest, the public still knows little about how hedge funds operate, partly because of a Securities and Exchange Commission regulation that prohibits them from soliciting investors.
Hedging is the practice of limiting risk by both buying stocks long and selling them short.
Hennessee divides funds into 23 strategy categories, including short-selling, event driven and merger arbitrage.
“Anyone who is lumping hedge funds together, and addressing them as a collective group, does not understand hedge funds,” said Joe Nicholas, author of “Investing in Hedge Funds” and chairman of the HFR Group of Companies, which analyzes hedge funds.
The funds that have done best this year are the funds that sell short. According to Hennessee, such funds are up about 18 percent this year.
Much of the resentment against the industry is bred by this technique, in which an investor borrows stock from a broker and sells it in the belief the stock will drop. When it does, he buys it back for a cheaper price and pockets the difference.
Main Street investors used to have the idea that shorting stock was “un-American,” said Charles Gradante, the chief executive of Hennessee.
The hedge fund managers that became famous on Wall Street–Michael Steinhardt, George Soros, Julian Robertson–all got rich making big directional bets on which way the market would go, especially by betting it would go down.
“The manner in which they made money,” said Gradante, “led people to believe that hedge funds were cowboys, wild and woolly.”
But today those big directional bets make up only 5 percent of the industry, and though they might not be the Wild West anymore, hedge funds are still a long way from mutual funds.
Some big differences
The main differences in regulation between the two is that mutual funds can’t leverage as much–that is, bet more than they have–can’t sell short as much and can’t let managers take a cut of performance instead of a flat percent of assets.
But the hedge fund camp takes exception to the notion that they are totally unregulated. Jeffrey Kuchta, chairman of Chicago-based Hedge Advisors Inc., points out that many hedge funds have to report their holdings to the SEC.
“First and foremost, hedge funds are not unregulated,” he said. “You can’t just go out there and run roughshod and do insider trading.”
Hedge fund fees are much higher than those of mutual funds. A typical mutual fund might take 1.3 percent of assets. The hedge fund manager might take 1 percent, then 20 percent of profits. The people paying higher fees are not being bamboozled; the higher fees allow them access to the funds with the highest returns, and the ability to try exotic strategies.
Mutual fund companies, worried about losing both their talented managers and their investors, have been offering up vehicles that could be described as hedge fund lite: They stray into hedge fund strategies without giving up the regulated structure. About a dozen funds like this exist, such as the Merger Fund, the Arbitrage Fund, and Boston Partners Long-Short Equity.
These funds typically charge much larger set fees that, unlike with hedge funds, won’t go down if the fund doesn’t make money.
Last summer Charles Schwab rolled out Schwab’s Hedged Equity Fund, which shorts 20 percent of its assets. The fund requires a $25,000 minimum investment, rich by most standards, but not those of the hedge fund industry where the typical minimum is $1 million.
So why would small investors be trying to break down the doors to hedge funds if the cost is higher?
In a word: returns. According to Van Hedge Fund Advisors, through September about half of hedge funds actually showed gains while the average mutual fund lost one-quarter of its value.
Nicholas argues that hedge funds don’t pose any more of a problem for unsophisticated investors that other investment vehicles such as penny stocks.
He thinks full and clear disclosure, not prohibitions, should be the way to keep investors safe in hedge funds.
“Certainly, anyone who is allowed to buy stocks should be allowed to buy hedge funds,” Nicholas says. “Are stocks appropriate for widows or orphans?”
