Myths of Hedge Funds

WSJ has a great article about Myths of Hedge Funds.

Myth #1: Hedge Funds are all the same. There are up to 25 different hedge-fund strategies which include funds invested in equity (both long and short), bankruptcies, mergers and acquisitions, high yield debt, bank debt, currencies, commodities, convertible debt, mortgage backed securities, trade claims, options, derivatives, volatility, etc. Each strategy has its own risk factors, return history, etc. Smart investors should heed the Socratic maxim of hedge funds -- Know Thy Strategy.

Myth #2: Hedge Funds are too risky. This is perhaps the biggest myth of all. For the first five years of this decade, hedge funds have returned a 7% (approximate) compound annual rate of return while the S&P has returned -2.2% per year. These positive returns in a bear market demonstrate that the funds are able to produce higher returns with less-than-market risk.

Myth #3: Hedge Funds are too expensive. No doubt about it. Index funds and mutual funds can be purchased at much lower fee structures. But to savvy investors that's not the issue. The key question is, net of fees, where do I want my capital invested? Hedge-fund fees are high as they are meant to compensate the top investment talent available. The question isn't, are hedge funds expensive? But rather, are the fees worth it? The market is saying yes.

Myth #4. Hedge Funds are secretive. Not so. Hedge funds are sold through privately distributed prospectuses which carefully describe, among other things, the fund's investment parameters, terms of investment, redemption rules, conflicts of interest, as well as the backgrounds and track records of key personnel. In addition, the funds provide annual GAAP audits detailing their assets. Many, although not all, funds disclose their portfolio holdings upon request. A fund that failed to provide this information would have a minimal chance of raising meaningful capital.

It is true that this information is not publicly available. This is not because managers are secretive, but rather because the funds are privately offered and SEC rules prohibit managers from making the information available.

Myth #5: Recent Hedge Fund regulations will prevent fraud. There is no reason to believe that recent SEC regulations will prevent fraud. Funds can avoid regulation by imposing a two-year lock-up on capital raised on or after February 2006. It is safe to assume fraudsters will avail themselves of that loophole. What the new regulations have done is to reduce the liquidity normally provided to investors. Funds of funds now have to choose between allocating to funds which impose two-year lock-ups (as many of the top funds are now doing) thereby reducing investor liquidity rights, or selecting funds that are not their "first choice" but will register and provide annual liquidity. That means that in the name of "protecting the public" the SEC just reduced the liquidity available to funds of funds and hedge-fund investors. While fraud will never be entirely eliminated, continually evolving due diligence and other best-practice standards should reduce the scope and frequency of fraud.

Myth #6: Funds-of-funds investors need more regulatory protection than hedge-fund investors. Of the $1 trillion in hedge funds, approximately $335 billion comes from funds of funds. Most funds of funds require individual investors to be qualified purchasers (those with $5 million or more in investable assets), so they don't prey on widows and orphans. Less than 3% ($8 billion) of all capital invested in funds of funds is estimated to be in publicly registered "fof" vehicles where investors who are not qualified purchasers can invest. Hardly worth a new regulatory scheme. In fact, like hedge funds, funds of funds provide monthly track records, annual audited reports and detailed prospectuses which disclose conflicts of interest, investment terms, etc. Fund-of-fund annual reports are required to disclose any investment that exceeds 5% of total assets. Many funds of funds are fully transparent.

Myth #7: Hedge Funds destabilize markets. While the collapse of Long Term Capital Management in 1998 was immensely destabilizing for the markets, it is really the exception that proves the rule. Most funds run modestly leveraged, since they do not want to incur a loss large enough to jeopardize the franchise. Today hedge funds are a key source of liquidity for the markets. They make markets more efficient, and can create value, since they often actively unlock corporate value by pressuring managements to make necessary changes. Would you rather buy a stock owned by a passive mutual fund or one owned by hedge-fund managers insistent upon corporate responsibility?