Last year, the stock market languished in negativeterritory for the first 10 months beforebreaking out. This year's stock market againappears to be stalled. What's an investor to do? As away to recoup double-digit returns, some investors areturning to hedge funds. These loosely regulated privateinvestments, often shrouded in secrecy, employ adizzying array of strategies, including trading in equities(both long and short), currencies, distressed debt,and credit derivatives. Often only available to accreditedinvestors with $1-million-plus net worth or$200,000 per year income, the popularity of hedgefunds has compelled brokerage firms such as CharlesSchwab & Co to form affordable funds. SchwabHedged Equity Fund (SWHEX) now offers minimumsas low as $25,000 for nonaccredited investors.
So what's the big attraction for taking part in theseso-called super capitalist ventures? Most recently, it'sbeen the manager's superb returns. ESL Investmentshedge fund manager Edward Lampert, best knownfor the merger of Sears Roebuck & Co and Kmart,boasts a 69% return for his investors over the pastyear and 29% annually since the fund's 1998 inception.James Simons' Medallion Hedge Fund postedannualized returns of 34% since its 1998 inception.With returns like these, understandably, hedge fundsattract a lot of interest from investors. But youshould be aware of two significant drawbacks tohedge funds before you invest.
Lack of transparency. Most hedge funds do notdisclose to the public or their investors what themanager is investing in. In other words, an investoris never certain how much risk they are undertaking.History suggests that brains alone are not necessarilyenough for a hedge fund to succeed. In 1994, agroup of Nobel Laureates and experienced securitiestraders formed a hedge fund called Long TermCapital, which received lavish praise from the financialpress along with $1.3 billion of investor money.Within a mere 4 years, the fund teetered on the brinkof bankruptcy and threatened the collapse of theworld financial markets. The Federal Reserve had tostep in with a $3.5-billion rescue.
The high cost of investing. Investors expect topay fees for professional financial help. But the feescharged by many hedge fund managers border onoutrageous. While the typical hedge fund charges 1%to 2% annually based on your capital balance plus20% of the profits, fees can be much higher. Forexample, James Simon's Medallion Hedge Fundcharges a 5% annual management fee plus a whopping44% of profits. As an investor, to some extent,you don't care what the manager earns in fees as longas you are making above-average returns. But thereare thousands of hedge funds and only a handfulhave produced stellar returns. This past year alone,an estimated 270 hedge funds terminated operationsdue to poor performance.
You should also be aware that many hedge fundsdo not allow you to withdraw your funds until anextended period of time, some as long as 5 years. Yetone notable benefit of hedge funds is that theirreturns have a low correlation with the broad stockmarket, thus enhancing diversification while reducingoverall portfolio volatility. Hedge funds may beworth considering, but you should first do a greatdeal of due diligence before investing in them.
, is the founder of the Welch Group,
LLC, which specializes in providing fee-only wealth management
services to affluent retirees and health care professionals throughout
the United States. He is the coauthor of J.K. Lasser's New Rules
for Estate and Tax Planning (John Wiley & Sons, Inc; 2001). He welcomes
questions or comments at 800-709-7100 or visit www.welchgroup.com.
This article was reprinted with permission from the Birmingham Post Herald. He
thanks his partner Scott Lee for his assistance with this article.
Stewart H.Welch III, CFP®, AEP