Take a Good Look at Today's Hedge Funds

Physician's Money Digest, March15 2004, Volume 11, Issue 5

Remember Long-Term CapitalManagement? It was the hedgefund that went belly-up in thelate 1990s and nearly took the Americanfinancial infrastructure with it. Mostinvestors today think about this kind offund when they hear the word "hedgefund." They envision volatile, risky, leveragedinvestments with high fees and littletransparency. Fortunately, the industry hascome a long way in a short period of time.

Modern Fund Strategies

One approach to hedge funds that isbecoming more widely accepted by institutionaland high-net-worth investors iscalled a Fund of Hedge Funds (FoHF). Thisapproach pools investments of multiplehedge fund strategies into one fund andseeks to mitigate the risks normally associatedwith individual funds. As you probablyknow, the universe of hedge fundsconsists of various investment strategies.And these strategies fall into the followingfour categories:

  • Relative value—Capitalizing on thepricing inefficiencies found among individualmarket securities
  • Event-driven—Investing on anticipatedoutcomes of company-specific situationsin various industries
  • Long/short equity—Taking bothlong and short positions in securities
  • Global macro—Seeking to benefitfrom macroeconomic opportunities in theglobal equity, fixed income, currency, andcommodities markets

Because these strategies go in and outof favor, investing in a fund that invests inall of these strategies simultaneouslyallows your portfolio to have significantlyless volatility. So, how much of your portfolioshould be allocated to a FoHF? Whileadvisors typically recommend between5% and 20%, your decision should bebased on a number of factors, includingthe type of hedge fund, risk tolerance,and time horizon for liquidity.

FoFH Index Evolution

Index smarts:

The latest development in the evolutionof hedge fund investing is the creationof investable hedge fund indexes.Like index mutual funds, FoHF indexes aretypically created using a variety of quantitativeand qualitative screens in anattempt to represent the hedge fund universe. Consider them thecore component of hedge fund exposure.

While once only reserved for sophisticatedinstitutional investors, FoHFs aremoving downstream, enabling more eligibleinvestors to have greater access tothem. While a few hedge funds havegained notoriety as a result of shakytrading strategies, not all hedge fundsare excessively speculative. Hedge fundsdo, however, contain many risks thatinvestors need to understand beforeinvesting in them. Many FoHFs aredesigned to minimize volatility and providecertain investors with a prudent wayto enhance their overall portfolio.

Edward Papier, CIMA, CFP®, issenior vice president of LexingtonAdvisors, an independentwealth management and investmentadvisory firm with officesin Boston, New York, and Washington,DC. He welcomes questions or commentsat 800-626-1566.