Hedge funds not worth crying over

Published: Saturday, July 1, 2006 at 6:01 a.m.
Last Modified: Saturday, July 1, 2006 at 12:00 a.m.
NEW YORK - Hedge funds seem so glamorous, but small investors who lack the money for their minimum investments and hefty management fees shouldn't shed a tear - hedge funds' recent performance just doesn't look that stellar.
The funds have been in the news lately because of a June court decision that kept them outside the watchful eye of Securities and Exchange Commission regulators. The funds remain basically unregulated and their reporting standards are loose, to say the least, but their returns for the year to date still appear to be unenviable.
As of June 20, a Diversified Hedge Fund Composite calculated by Merrill Lynch was up 3.42 percent for the year to date. The average U.S. equity long/short hedge fund was doing worse, down 0.45 percent.
That doesn't look too great at a time when nearly risk-free three-month Treasury bills are yielding near 5 percent.
"Average hedge funds, whatever that means, appear to be up in the 4 to 4.5 percent" range, said Phil Maisano, head of alternative investments of Mellon Asset Management.
There is no exact definition of a hedge fund. In general, hedge funds, like mutual funds, pool investors' money. Unlike mutual funds, they don't have liquidity requirements, they can place unlimited dollars in one investment and there are no limits on conflicts of interest.
Hedge funds are free to take any risk that strikes their managers' fancy. They can sell stocks long or short, borrow massively to amplify a trade and conduct arbitrage, in which they buy and sell a security in different markets to profit from the difference between prices.
Hedge fund managers pitch investors by saying their bold risks will lead to outsized returns. That's why hedge fund managers often charge hefty fees - 1 percent to 2 percent of assets plus 20 percent of returns is not unusual. The funds are almost always closed to everyone but individuals with a net worth above $1 million or income exceeds $200,000.
These wealthy individuals and well-funded institutions often agree to lock-up periods of longer than a year when they buy a hedge fund. Once their (quite large) minimum investment is in the fund managers' hands, the investor can't get it back for the length of the lock-up period.
None of this has scared off investors: Hedge fund assets are estimated at $1.3 trillion, compared to $9.5 trillion managed by mutual funds.
Many subcategories of hedge funds do look like they're delivering higher returns than the wider market this year. For instance, the Dow Jones Distressed Securities Benchmark was up 6.60 percent through June 20, which looks much, much better than the Standard & Poor's 500, which was up 2.27 percent for the same period.
But the hedge funds' returns should be taken with an extra large grain of salt. Hedge funds are nowhere near as transparent as a single stock, a market index or a mutual fund.
Consider the following caveat in Merrill's "Hedge Fund Monitor":
"Hedge fund indices may not be fully representative of hedge fund returns. Not all hedge funds are in hedge fund indices. The number of funds in each strategy sub-index is relatively small. Some reasons for this non-inclusion are funds closed to investors that do not report their performance to public databases, funds with poor returns that stop reporting performance, and successfully incubated funds that enter databases with 'instant' track records with a very low level of historical assets."
The SEC says on its Web site that hedge funds invest in highly illiquid securities that may be difficult to value. "Moreover, many hedge funds give themselves significant discretion in valuing securities."
It's hard for an investor to find out what a hedge fund's real returns are "if I'm in a lock-up for five years and this quarter, you say I made 5 percent on my money," said Matthew Smith, vice president and portfolio manager at Smith Affiliated Capital in New York, a boutique fixed-income firm.
Smith competes with hedge funds, but he's not alone when he says, "these numbers that these hedge funds are pushing out are wishbook numbers."
Money manager Presidio Financial Partners LLC did a study finding that an investor with a properly diversified portfolio of investments from 1990 to March 2006 would have had a slightly better return than an investor who put their money in the HFRI Fund of Funds Composite Index. (Presidio defined a properly diversified portfolio as 40 percent taxable bonds, 20 percent U.S. large-cap stocks, 10 percent high-yield bonds, 15 percent international equity, 10 percent U.S. small-cap and 5 percent emerging market equity.)
Presidio found that only 250 of 8,000 individual hedge funds delivered performance in line with their higher fees. Of "hedge funds of funds," which are investment companies that invest in different hedge funds, only 12 to 15 of more than 1,000 hedge funds of funds, delivered performance in line with their fees.
Presidio has its own agenda, as it manages money for people with more than $10 million. One of the services it charges its clients for: picking the very best hedge funds of funds.

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