Hedge funds offer traditional portfolios a means of diversification.Investors on Wall Street have lost millions in the last few years. Tech stocks crashed, and even the conservative investors who put money into something as traditional as a utility company like Enron took a historic beating. On the outside fringes of the investment community are hedge funds, known in the financial circles as alternative investment vehicles. Although the funds are set up similarly to mutual funds -- in that the fund manager controls the money and the investors see the return after a percentage is taken by the manager -- hedge funds are like nothing else when it comes to investing, experts say.
A hedge fund is organized as a legal partnership by the people who invest in it. The partnership could be only a couple of investors or it could be as many as 100 people. These people are usually high net-worth individuals, and they normally only put a small percentage of their overall portfolio into a hedge fund. Hedge funds are private limited investment partnerships that by definition are allowed to "hedge" against a declining market or sector to meet the objectives of the partnership. The first hedge fund was formed in 1949 by Harvard graduate and Fortune Magazine reporter Alfred Winslow Jones, who believed he had a better investment management approach.
The foundation of his investment management process centered on "hedging" his long stock positions by selling short (profiting from a decline in stocks) to protect against market risk. He operated under the radar screen for years before a 1966 Fortune magazine story titled "The Jones That Nobody Can Keep Up With." The article highlighted that his partnership had outperformed the best mutual fund by more than 85 percent over the preceding five years with his unique Long/Short investment process. A New IndustryThis marked the beginning of the hedge fund industry, as it attracted investors seeking better investment returns and professional money managers attracted to performance-based compensation. By 1968 there were about 200 hedge funds operating including partnerships run by George Soros and Warren Buffett. Today the number of U.S.-based hedge funds is estimated to be 4,600. As a means of protection or defense against a financial loss, Hedge fund strategies vary widely from fund to fund, but the entire purpose of hedge is to protect and preserve capital. Hedge Funds often are characterized as risky, speculative investment vehicles intended to deliver huge returns on secretive strategies. Funny thing is the objective of most hedge funds is the exact opposite. The majority of hedge funds seek to deliver positive returns in all market conditions with reduced risk and a focus on capital preservation. Most intend to deliver low volatile absolute returns not correlated to the overall market, say 1 percent per month, which means delivering positive results as often as possible and without excuses. Although there are approximately 14 hedge fund styles, the five most popular are fund of funds (a hedge fund that invests in other hedge funds), value, market neutral, aggressive growth and opportunistic. Hedge funds have some defining characteristics, including: Accredited investors: For starters, hedge funds are intended only for "accredited" investors. An accredited investor is defined as an investor with a net worth of $1 million or more and/or one with income in excess of $200,000 in each of the two preceding years. The typical investment minimum starts at $250,000 and is targeted toward such investors as high-net-worth individuals, pension funds, endowments, etc. Liquidity: Hedge funds usually have liquidity restrictions. For the most part, investors have to give 30 or 60 days' notice to the fund and might be subject to quarterly lockup restrictions that are detailed in the partnership or fund agreement. Investment Strategy and Disclosure: Hedge funds have significant investment flexibility and generally do not disclose their holdings. They are allowed to utilize short selling, options and leverage, and maintain big cash balances where traditional investments like mutual funds generally do not have this flexibility. In fact, most hedge funds utilize these techniques to protect capital, not to increase risk. Alfred Jones once said these are "speculative tools used for conservative purposes." Limited regulation and no public advertising: Since hedge funds are lightly regulated and are intended only for accredited investors, not the masses, there is no public advertising. These rules are meant to protect individual investors who are not sophisticated enough to properly evaluate and research funds. Management incentive fees: Typically, hedge funds earn a 1-2 percent management fee and/or 20 – 50 percent of the net profits of the fund subject to certain restrictions. Hedge fund managers also are expected to have the bulk of their net worth in the fund so their interests are aligned with their investors. Warren Buffet has referred to this as "eat your own cooking."
Hedge Funds as a Mainstream Investment
The recent announcement by the Securities and Exchange Commission of new controls on hedge-fund advisers was significant not merely for its practical implications but also for the SEC's symbolic nod to the fact that we are in the early stages of a fundamental shift in how people invest. Hedge funds, once the exclusive province of the fabulously wealthy, are going mainstream. Back in the early 1990s, minimum investments of $500,000 to $1 million were typical. The funds invested primarily in exotic derivatives, swaps, options and the like and used leverage -- borrowed money -- to enhance returns. Times have changed. It is estimated the hedge-fund industry has grown to more than 7,000 funds with a collective $870 billion in assets under management. But these are not the hedge funds of the past. Many have modified their investment structure to allow smaller investments (as low as $100,000 to $250,000), and they often invest in more traditional securities. Perhaps most tellingly, such traditional investors as pension and insurance funds now allocate significant portions of their portfolios to hedge-fund investments. Increased institutional investment, as well as the need for alternative investment options that offer healthy returns without excessive risk in an underperforming market, have contributed to the emergence of hedge funds as a mainstream investment.
Hedge Funds TodayYou might be asking yourself right now, why would anyone invest in a hedge fund? Simply put, they have offered high- net-worth investors superior risk-adjusted returns (net of all fees) compared with traditional investment funds. Hedge funds offer traditional portfolios a means of diversification because they pursue investment strategies with little or no correlation to traditional asset classes. In addition, studies have shown that hedge funds also offer balanced portfolios increased returns and lower risk, according to Nashville-based consultant, Van Hedge Fund Advisors Inc According to consultant Van Hedge Fund International Inc. for the last 15 years (Jan 1988 - March 2003) their hedge fund index has returned 15.6 percent with a standard deviation (measure of risk) of 8.8 while the S&P 500 has returned 11 percent with a standard deviation of 15.4. This means hedge funds have delivered 40 percent better returns with 76 percent less volatility risk, demonstrating that hedge funds in balanced portfolios help reduce volatility and increase performance. Hedge fund managers and the folks who invest with them say the investments are more important now than ever because by most accounts traditional investments aren't making anyone much money.
Kenneth W Sweet is managing member at Dover Management Group LLC. ________________ 8627 113th Lane N.E. Kirkland, WA 98033 The United States of America
All information included herein is not intended to be, and should not be construed as, an offer or a solicitation of an offer of securities of any of the funds managed by Dover Management Group LLC. Any such offer or solicitation will be made only after you have received the Confidential Private Offering Memorandum. Access to information about the funds is limited to investors who either qualify as accredited investors within the meaning of the Securities Act of 1933, as amended, or those investors who generally are sophisticated in financial matters, such that they are capable of evaluating the merits and risks of prospective investments.
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