Realize the Possibility for Hedge Funds

Roccy DeFrancesco, JD

Physician's Money Digest, November15 2003, Volume 10, Issue 21

Most investors think of a hedge fund as amutual fund on steroids that they can'tafford to get into. While hedge funds canprovide significantly higher or lowerrates of return than moderate or aggressive mutualfunds, the goal of most hedge funds is to retain principaland take advantage of upside potential in themarket. For most hedge funds, the costs are 1% to1.5% annually on the assets under management and20% on the gains made during the year.

In essence, hedge fund managers have incentiveto protect the principal and grow the fund as muchas possible. Additionally, if the hedge fund experiencesnegative returns during a given year, the 20%fee on gains doesn't kick in until the deficiency fromthe previous year is made up. Hedge fund managersare considered the elite of the elite investment managersand are expected to generate returns in excessof the stock market indexes.

Basic Strategies

Most investors assume that all hedge funds arealike, investing on the edge of what makes sense, hopingto receive a high return. These investors aren'taware of the number of hedge funds that are conservativeand protective of capital. This type of fund is insharp contrast to a roll-the-dice fund looking to hit ahome run each year with its investments.

Depending on an investor's tolerance for risk andunderstanding of the equity and bond markets, they'llusually gravitate toward 1 hedge fund. Although allhedge funds aim to achieve high rates of return, theydon't use the same strategy to achieve their goal.Following is a list of strategies hedge funds use wheninvesting your money:

  • Selling short—selling shares without owningthem, hoping to buy them back at a future date whenthey're at a lower price.
  • Using arbitrage—exploiting pricing inefficienciesbetween related securities.
  • Trading options or derivatives—contracts whosevalues are based on the performance of any underlyingfinancial asset, index, or other investment.
  • Investing "on the come"—investing in companiesthat anticipate a merger, hostile takeover, spinoff,completion of bankruptcy proceedings, etc.
  • Investing in deeply discounted securities—investing in companies about to enter or exit financialdistress or bankruptcy, often below liquidation value.

Affordable Managers

With such a high entry fee (between $250,000 and$10,000,000), most investors can't afford to participatein hedge funds. Investors who do have the moneyto participate usually feel uncomfortable putting sucha high percentage of their liquid portfolio into a fundthat has a volatile reputation. What many investorsdon't realize is that it's possible to get into a hedgefund without a $250,000 initial funding commitment.

Almost all hedge funds have a limit on the numberof investors they can have in their funds. If you lookhard enough in the hedge fund marketplace, you canfind a hedge fund manager who will take you on as aclient under the same assumptions as a normal hedgefund, but will simply manage a single account underyour name with an appointed power of attorneyallowing them to trade your money as they see fit.Usually, these types of hedge fund managers will limitthe amount of clients they represent.

Today's lesson:

Hedge funds can be a nice way to have a percentageof your portfolio grow at a rate well in excess ofthe stock market indexes and aggressive growthfunds. As with any investment, make sure you do yourhomework before you invest in a hedge fund. If possible,don't let the fund exceed 20% of your entire stockmarket portfolio. If set up correctly,you could have a certain percentage of your post-taxinvestment portfolio in a hedge fund without havingto find $500,000 to get in.

Roccy DeFrancesco is an attorney and author of"The Doctor's Wealth Preservation Guide." He hasrun a medical practice and lectured for many stateand national medical associations. For a free assetprotection, income, and estate tax reduction CD,or for questions or comments, call 269-469-0537or e-mail roccy@wealthpreservation123.com.