Hedge Fund Investing

By: Money_and_Markets

Monty Agarwal writes: Hedge funds and the managers who run them have been getting a lot of publicity lately — and not of the flattering kind.

We have massive Ponzi schemes, equally massive losses and outsized systemic risks that are enough to frighten away even the hardiest of investors.

So before you leap, you need to look — carefully and deeply into this industry. When you do, however, you’ll also find that there’s a lot more to hedge funds than has been making it into the evening news …

Hedge funds are an integral part of our financial investment landscape. They often outperform the broad stock market by wide margins. Many are designed to make money in ANY market environment. And they are now more accessible to investors via a fast-growing new vehicle — funds of hedge funds.

This morning, I’ll give you a basic primer on hedge funds to help you decide if these unique investments are possibly right for you. And in the future, I’ll introduce you to specific funds — and strategies they use — for successful global investing.

What Are Hedge Funds?

The first hedge fund came out in 1949 as a strategy to neutralize the effect of overall market movements on a portfolio.

The strategy was simply to buy stocks that were expected to rise and selling short stocks expected to fall. The concept was to add BALANCE — to produce returns that were not market-dependent and tended to hedge a portfolio’s market exposure.

Nowadays, that has changed in a very fundamental way: Besides protecting a portfolio from downside risk, hedge funds often go for maximum return by deploying large amounts of leverage and investing in several asset classes among global markets.

Who Invests in Hedge Funds?

Hedge funds are private partnerships that are open to a limited number of investors, with qualification criteria determined by the SEC. To get into one, you’ll need to prove you have a net worth greater than $1 million and meet a minimum income requirement.

The reason for these stringent requirements is simple: The SEC feels that hedge funds are riskier and less transparent than mutual funds and most other investments.

Beyond high-net-worth individuals, institutional investors are also a dominant force behind the rising popularity of hedge funds. Two such groups are …

#1. Pension Funds

Unfortunately, U.S. corporate and government pension funds rarely have enough money in their kitty to cover all their expected future liabilities to their members. In fact, assuming the most likely future scenario, the expected shortfall is almost $1.5 trillion!

This is a major reason why pension fund managers have reached beyond traditional investment vehicles to seek outsized returns. And many fund managers think hedge funds are the best places to find them.

Estimates vary. But up to 20 percent of European and American pension funds — plus 40 percent of Japanese pensions — are believed to invest in hedge funds.

Two prime examples: As of January 2, 2009, the two largest government pension funds investing in hedge funds were the California Public Employees’ Retirement System with a total market value of $188 billion and the Ontario Teachers Pension Plan with $108 billion in net assets.

#2. Endowments

Endowments include colleges and universities as well as charitable institutions. And in the latest National Association of College and University Business Officers Endowment Study, hedge funds made up 18 percent of college and university portfolios on a dollar-weighted basis. This puts hedge funds second only to stocks (with a 48 percent allocation).

Additionally, the data reveals another not-so-surprising trend: The larger the institution, the higher the percentage of assets invested in hedge funds.

Even assuming no hanky-panky, the risks are clear. But don’t ignore …

Four Key Benefits Of Investing in Hedge Funds

Benefit #1 — True diversification across multiple asset classes. Hedge funds operate in any and every asset class imaginable, from the traditional equities and bonds to currencies, commodities, real estate, and even fine art.

Benefit #2 —True global diversification. While most of the strategies used by hedge fund managers are concentrated in developed countries, there are funds focused on the emerging markets of Asia, Latin America, and Eastern Europe. I’m also seeing hedge funds foray into frontier markets — extremely underdeveloped markets of Africa and the Middle East.

Benefit #3 — Non-correlation with traditional investments. The instruments used by hedge funds are diverse. Hedge funds can utilize futures, swaps, and options. This allows them to produce returns that vary wildly from those of broad markets and more common investments.

Benefit #4 — The concept of absolute returns. Hedge funds exist to make money in any market environment. They’re not content to help you “lose less money than the averages.” They make their fees only if they give you a positive absolute return. This is a very powerful incentive. It’s backed by years of solid performance. And I think it’s the main reason the hedge fund industry has been attracting capital from all kinds of investors.

The following chart shows the annualized returns from 1997 to 2008 of various hedge fund strategies as compared to the S&P 500 index.

Among six of the most widely used hedge fund strategies, five have greatly outperformed the S&P 500 Index; only one fell short.

Clearly, if you are qualified for a hedge fund — or a fund of hedge funds — and you can gain the knowledge to help you avoid the pitfalls, this is not a track record you can afford to ignore.

Best regards,

Monty

Editor’s note: Monty Agarwal’s new book, The Future of Hedge Fund Investing, has just hit the market and can be ordered by clicking any one of these links:

http://www.amazon.com/Future-Hedge-Fund-Investing-Regulatory/dp/0470537442/

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