Before You Jump into a Hedge Fund

Once solely for the ultrarich, these vehicles are now attracting the merely well-heeled, who may be still better off with index funds

By Chris Farrell

One of the marks of genius for entrepreneurs is taking an expensive, exclusive product enjoyed by the rich and profitably turning it into a cheap, mass-produced item enjoyed by everyone. Countless examples of this dynamic are at work, ranging from refrigerators and air conditioners to antilock brakes and cell phones.

The same goes for finance, especially with the remarkable democratization of credit and investment over the past half century. Credit cards. Mutual funds. Retirement savings accounts. Today, almost every working adult has at least one credit card, and more than half of American households own equities.

Now, hedge funds, those mysterious private investment vehicles for the superrich, are opening up to the merely well-heeled. In the '80s and '90s, when the stock market marched to unprecedented heights, America's equity culture lionized swashbuckling hedge-fund managers. Buccaneers like Julian Robertson, George Soros, John Meriwether, and James Cramer became legends by risking big and earning outsized returns.


  The real appeal of hedge funds, however, was financial snobbery. Investing with one of these titans meant membership in a discreet, truly exclusive private club. Imagine the cachet that came from standing at a reception in Midtown Manhattan in the '90s and listening to other people discuss their mutual funds, dot-com investments, and stock options, and being able to quietly murmur that your money was invested with Soros. "Hedge funds became symbols of the richest and the best," writes Roger Lowenstein in When Genius Failed: The Rise and Fall of Long-Term Capital Management.

Still, this is a club most people will want to avoid. While some hedge-fund managers will continue to coin money, it's doubtful many investors will do better than the Standard & Poor's 500-stock index benchmark. Not every evolution toward greater financial democracy is worth participating in.

Just what is a hedge fund? The definition is fuzzy, since the investment vehicle is an eclectic mix. Some hedge funds make big bets on major moves in national or global markets. Others exploit relative differences in prices in comparable securities. And some specialize in sectors of the market, such as convertible bonds. But they have several common characteristics.


  Almost all hedge funds use a variety of sophisticated investment techniques, including leverage and short-selling (borrowing a security in anticipation that its price will fall and can be replaced at a much lower price). They're organized as small private partnerships. Money managers typically pocket a 1% fee, plus 20% of the profit.

They're also lightly regulated. "Hedge funds are defined by their freedom from regulatory controls stipulated by the Investment Company Act of 1940," economists Stephen J. Brown of New York University and William N. Goetzmann and Roger G. Ibbotson of Yale University wrote in a 1998 article on the industry. "These controls limit fund leverage, short-selling, holding shares of other investment companies, and holding more than 10% of the shares in a single company."

The term hedge fund comes from the phrase "hedging your bets." These partnerships traditionally preserved wealth in good and bad markets. That certainly was the approach of Alfred Winslow Jones, the sociologist-turned-journalist-turned-money manager who pioneered the modern hedge fund in 1949. But the industry took a more aggressive turn in the '90s, and many funds started making bigger bets.

The U.S. now has 6,000 hedge funds, vs. some 880 in 1991 and 215 in 1968. These funds control $500 billion to $600 billion (that is, before leverage -- and hedge funds typically borrow a ton of money). Here's an eye-opening statistic: According to Morgan Stanley, the money flow into hedge funds last year was roughly comparable to the sums invested in equity mutual funds, although the latter option dwarfs the hedge-fund industry in size.


  Hedge funds have been tarnished in recent years. Under the leadership of legendary trader John Meriwether, Long-Term Capital Management imploded in the late '90s. Its collapse nearly sank the global financial system, and, at the urging of the Federal Reserve, LTCM had to be bailed out by Wall Street. (Lowenstein's book, When Genius Failed, is a brilliant telling of the rise and fall of LTCM, and a cautionary saga for anyone contemplating putting money into a hedge fund.)

Soros retired from the business to become a full-time philanthropist and author. Robertson closed shop after several miserable years. The same holds for Cramer, who has reinvented himself as a television scold. Nevertheless, some investors still clamor to hand over their money to a hedge-fund gunslinger. The feverish enthusiasm is raising concerns among the Wall Street cognoscenti that a hedge-fund bubble is in the making.

"Unlike some others, I do not think we are in a hedge-fund bubble that is going to end in disaster," says Bryon R. Wein, chief investment strategist at Morgan Stanley. He adds: "I expect a number of new and old funds to close down, but the concept will endure."


  Bubble or not, it's increasingly apparent that a lot of hype is built into the hedge-fund mystique. For instance, economists Brown, Goetzmann, and Ibbotson looked into offshore hedge fund performance from 1989 through 1995. (The tax-haven offshore industry is huge.) They found the average offshore hedge-fund return was 13.6% during that period, vs. a 16.5% annual gain for the S&P 500 (although that return was earned with lower volatility than the overall market).

What's more, the rate of attrition for funds was about 20% a year. Considering that short life cycle, it may be harder to pick a good long-term hedge fund than a stock investment. More money is pouring into the industry than can be profitably invested.

The biggest concern, though, may be a lack of transparency. Has Enron taught investors anything? Hedge-fund finances are opaque, and a lack of openness is an invitation to abuse as industry growth explodes.

Put it this way: Average well-heeled investors haven't missed out on much in being excluded from the hedge-fund club. They'd do far better parking their money in a boring, plain vanilla, broad-based global equity index fund.

Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

Edited by Douglas Harbrecht

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