Chapter 6

Hedge Funds and Other Managed Alternatives

In This Chapter

Making sense of hedge funds

Deciphering wrap or managed accounts

Placing money with private money managers

Wealthier investors with large amounts to invest (typically well into the six figures) usually have more choices when it comes to investment vehicles. Some financial advisers and money management firms pitch alternatives to mutual funds to these folks.

The unbelievably wide variety of mutual funds enables you to invest in everything from short-term money market securities to corporate bonds, U.S. and international stocks, precious metals and other commodity companies, and even real estate funds. Although funds can fill many investing needs — as I discuss in Chapter 1 — you may be interested in and benefit from directly investing in things such as real estate, your own business, and many other investments.

During the early to mid 2000s, hedge funds were proliferating and promising high returns with less risk. In the prior edition of this book, I warned readers, “As with all sales pitches, you must separate fact from fiction and hype.” This chapter can help you do just that if you’re rolling in the dough. Plenty of hedge fund investors got burned during the financial market turmoil in the late 2000s.

Other types of privately managed investment accounts, such as wrap accounts, exist that have some things in common with mutual funds. The following sections provide some background that you need to know if you’re going to consider these fund alternatives.

Hedge Funds: Extremes of Costs and Risks

Hedge funds, historically an investment reserved for big-ticket investors, are seemingly like mutual funds in that they typically invest in stocks and bonds. They have the added glamour and allure, however, of taking significant risks and gambles with their investments. Hedge funds may take risks by purchasing derivatives (see Chapter 2), or they may bet on the fall in price of particular securities by selling the securities short. (When you short sell, you borrow a security from a broker, sell it, and then hope to buy it back later at a lower price.) Some hedge funds even invest in other hedge funds.

This section takes a closer look at hedge funds and gives you a clear idea of what hedge funds are and what you need to know and do before you consider investing in one.

Getting the truth about hedge funds

In the prior edition of this book written in 2007, I warned, “Although hedge funds have recently been the buzz in some investment circles and some wealthier investors have been dropping money into them, they may not be the best choice for you. Hedge funds are typically a far riskier investment than your typical mutual fund. What’s the hidden truth about these funds? The following list highlights some of hedge fund’s dangers:”

Hedge funds have a much higher risk than mutual funds

When a hedge fund manager bets right, he can produce high returns. When he doesn’t, however, the fund manager can have his head handed to him on an expensive silver platter. With short selling, because the value of the security that was sold short can rise an unlimited amount, the potential loss from buying it back at a much higher price can be horrendous. And even the most experienced investing professionals can also lose a pile of money in no time when they invest in derivatives. Hedge fund managers have also been clobbered when a previously fast rising commodity like natural gas or copper futures plunges in value.

A number of hedge funds have gone belly up when their managers guessed wrong. In other words, their investments did so poorly that investors in the fund lost all their money. As I discuss in Chapter 2, the odds of this happening with a mutual fund — particularly from one of the larger, more established companies — are nil.

Hedge funds have much higher fees than mutual funds

Hedge funds charge an annual management fee of about 1 to 2 percent and a performance fee, which typically amounts to a whopping 20 percent of a fund’s profits. Veteran investment observer Jack Bogle said of hedge funds and the high fees that are extracted and paid to the hedge fund’s managers (and not their customers), “Hedge funds are a compensation strategy not an investment strategy.”

Hedge funds aren’t subject to the same regulatory scrutiny

A Forbes 2004 article on the hedge fund industry entitled “The Sleaziest Show On Earth” referred to the industry as, “. . . a business rife with exorbitant fees, phony numbers, and outright thievery.” During the severe stock market decline in the late 2000s, many hedge funds did poorly, and some went under or were exposed to be fraudulent Ponzi schemes, the most notorious being the fund run by the now jailed Bernie Madoff.

If that’s still not enough to convince you from the perspective of one of the nation’s best business magazines that caters to those affluent enough to invest in such funds, consider this: Forbes went on to say, “Hedge funds exist in a lawless and risky realm, exempt from the rules governing mutual funds, equities, and most other investments. Hedge funds aren’t even required to keep audited books — and many don’t. These risky funds often are guilty of inadequate disclosure of costs, overvaluation of holdings to goose reported performance and manager pay, and cozy ties between funds and brokers that often shortchange investors.” For more about insufficient regulatory oversight of hedge funds, please see the “Investigating hedge funds” section later in this chapter.

Hedge funds have lower returns compared to mutual funds

Objective studies which I have seen, such as the one conducted by Princeton University’s Burton Malkiel, present an unflattering perspective on hedge fund industry returns. In short, hedge funds have produced lower average annual returns when compared with similar mutual funds.

If you want riskier investments, you can find aggressive mutual funds, or you can buy mutual funds on margin through a brokerage account, meaning that you make a down payment but control a larger investment (such as when you purchase a home with a mortgage). See Chapter 16 for more about the risks and rewards of buying on margin.

Investigating hedge funds

Unfortunately, hedge funds aren’t subject to the same regulatory scrutiny from the Securities and Exchange Commission (SEC) that mutual funds are. However, if you go against my advice and consider investing in a hedge fund, I suggest that you adhere to the advice the SEC offers. The following guidelines for evaluating hedge funds can help.

Read all the important documents

Take the time to read the fund’s prospectus or offering memorandum and all related materials. Doing so discloses the fees, managers, and overall investment strategy.

Make sure you understand the level of risk involved in the fund’s investment strategies and ensure that they’re suitable to your personal investing goals, time horizons, and risk tolerance. As with any investment, the higher the potential returns, the higher the risks you must assume.

Understand how a fund’s assets are valued

Funds of hedge funds and hedge funds may invest in highly illiquid securities (not easily and quickly converted into cash) that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund’s valuation process and know the extent to which a fund’s securities are valued by independent sources.

Ask questions about fees

Fees impact your return on investment. Hedge funds typically charge an asset management fee of 1 to 2 percent of assets, plus a performance fee of 20 percent of a hedge fund’s profits. A performance fee could motivate a hedge fund manager to take greater risks in the hope of generating a larger return. Funds of hedge funds typically charge a fee for managing your assets, and some may also include a performance fee based on profits.

These fees are charged in addition to any fees paid to the underlying hedge funds. If you invest in hedge funds through a fund of hedge funds, you’ll pay two layers of fees: the fees of the fund of hedge funds and the fees charged by the underlying hedge funds.

Understand any limitations on redeeming your shares

Hedge funds typically limit opportunities to redeem, or cash in, your shares (for example, to four times a year), and often impose a “lockup” period of one year or more, during which you can’t cash in your shares. (By contrast, mutual funds offer daily liquidity). These should be disclosed in the hedge fund’s prospectus.

Research the backgrounds of hedge fund managers

Know with whom you’re investing. Make sure hedge fund managers are qualified to manage your money and find out whether they have a disciplinary history within the securities industry. You can get this information (and more) by reviewing the adviser’s Form ADV. You can search for and view a firm’s Form ADV by using the SEC’s Investment Adviser Public Disclosure (IAPD) Web site (www.adviserinfo.sec.gov/IAPD/Content/IapdMain/iapd_SiteMap.aspx).

You also can get copies of Form ADV for individual advisers and firms from the investment adviser, the SEC’s Public Reference Room, or (for advisers with less than $25 million in assets under management) the state securities regulator where the adviser’s principal place of business is located. If you don’t find the investment adviser firm in the SEC’s IAPD database, be sure to call your state securities regulator or search the NASD’s BrokerCheck database for any information they may have.

Don’t be afraid to ask questions

You’re entrusting your money to someone else. You should know where your money is going, who is managing it, how it’s being invested, how you can get it back, what protections are placed on your investment, and what your rights are as an investor.

The SEC goes on to provide the following comments and suggested protections for those purchasing a hedge fund:

Hedge fund investors don’t receive all the federal and state law protections that commonly apply to most registered investments. For example, you won’t get the same level of disclosures from a hedge fund that you’ll get from registered investments. Without the disclosures that the securities laws require for most registered investments, it can be quite difficult to verify representations you may receive from a hedge fund. You should also be aware that, while the SEC may conduct examinations of any hedge fund manager that is registered as an investment adviser under the Investment Advisers Act, the SEC and other securities regulators generally have limited ability to check routinely on hedge fund activities.

The SEC can take action against a hedge fund that defrauds investors and has brought a number of fraud cases involving hedge funds. Commonly in these cases, hedge fund advisers misrepresented their experience and the fund’s track record. Other cases were classic “Ponzi schemes,” where early investors were paid off to make the scheme look legitimate. In some of the cases, the hedge funds sent phony account statements to investors to camouflage the fact that their money had been stolen. That’s why it’s extremely important to thoroughly check out every aspect of any hedge fund you might consider as an investment.

If you encounter a problem with your hedge fund or fund of hedge funds, you can send your complaint by using the SEC’s online complaint form at www.sec.gov/complaint.shtml.

Wrap (Or Managed) Accounts: Hefty Fees

Brokerage firms (Prudential, Merrill Lynch, Salomon Smith Barney, PaineWebber, and Morgan Stanley Dean Witter) that used to sell investment products on commission now offer investment management services for an ongoing fee rather than commissions. This change is an improvement for investors because it reduces some of the conflicts of interest caused by commissions.

Wrap accounts, or managed accounts, go by a variety of names, but they’re the same in one crucial way: For the privilege of investing your money through their chosen money managers, they charge you a percentage of the assets that they’re managing for you. These accounts are quite similar to mutual funds except that the accounts don’t have the same regulatory and reporting requirements as do mutual funds.

Wrap accounts management expenses are high. In fact, they’re up to 2 to 3 percent per year of assets under management. Remember that stocks have historically returned about 10 percent per year before taxes. So if you’re paying 2 to 3 percent per year to have the money managed in stocks, 20 to 30 percent of your return (before taxes) is siphoned off. You pay a good chunk of money in taxes on your 10 percent return. So a 2 to 3 percent wrap fee actually ends up depleting up to half of the profits that you get to keep after you pay taxes — ouch!

No-load (commission-free) mutual funds offer investors access to the nation’s best investment managers for a fraction of the cost of wrap accounts. You can invest in dozens of top-performing funds for an annual expense of 1 percent per year or less. Many excellent funds are available for far less — 0.1 to 0.5 percent annually.

So why do people invest through wrap accounts if they’re such a poor investment? Brokerage firms hoodwink investors into paying so much more for access to investment managers with clever marketing — slick, seductive, deceptive, misleading pitches.

The following are the key components of brokerage firms’ pitch for wrap accounts — and then the real truth behind the pitch:

“You’re accessing investment managers who normally don’t take money from small-fry investors like you.” Not a single study shows that the performance of money managers has anything to do with the minimum account size they handle. Besides, no-load mutual funds hire many of the same managers who work at other money management firms. In fact, Vanguard, the nation’s largest exclusively load-free investment firm, contracts out to hire money managers who typically handle only multimillion-dollar private-client accounts to run many of their funds. A number of other mutual funds are managed by private money managers who typically have high entrance requirements for their individual private clients.

“You’ll earn a higher rate of return, so the fees are worth it.” Part of the bait brokers use to hook you into a wrap account is the wonderful rates of returns that these accounts supposedly generate. You could’ve earned 18 to 25 percent per year, they say, had you invested with the “Star of Yesterday” investment management company. The key word here is “could’ve.” History is history. As I discuss in Chapter 7, in the money management business, many of yesterday’s winners become either tomorrow’s losers or its mediocre performers.

You must also remember that, unlike mutual funds, whose performance records are audited by the SEC, wrap account performance records include marketing hype. The SEC doesn’t audit wrap accounts. The most common ploy is showing the performance of only selected accounts — which turn out to be (you got it) only the ones that performed the best!

The expenses you pay to have your investments managed have an enormous impact on the long-term growth of your money. If you can have your money managed for 0.5 to 1 percent per year rather than 2 to 3 percent, you have an enormous performance advantage already.

“A wrap account is tailored to your personal needs.” Thousands of different mutual funds are available out there, covering every possible combination of investments and degree of risk. You can find a mutual fund and develop a portfolio of funds that meets your objectives and risk tolerance. Some wrap accounts have only funds that are managed by a particular brokerage firm, making it impossible for you to invest in the best from the universe of all funds.

Moreover, if your portfolio ever begins to drift from your objectives, buying into a new mutual fund is much easier than ending a relationship with a broker who sold you the wrap account.

“There’s little difference in cost between wrap accounts and mutual funds.” The worst and most inefficient mutual funds can have total costs approaching that of a typical wrap account. But you’re informed, right? You’re not going to invest in the highest-cost funds. Chapters 11 through 14 detail which mutual funds offer both top performance and low cost.

Private Money Managers: One-on-One

In the world of money management, added benefits — snob appeal and ego stroking for many — come with having your own private money manager. First of all, you generally need big bucks, often $1 million or more, to gain entrance. A private money management company allows you to sit down and visit with a personal representative and perhaps even the investment manager. The company may lavish you with attention and glossy brochures. You hear how your money not only receives individualized and personalized treatment but also how superb the investment manager’s performance has been in prior years.

Even if you have big bucks, you probably don’t need a private money manager for two simple reasons:

The best, average, and worst private money managers earn returns comparable to their counterparts in the mutual fund business. And as I mention earlier in this chapter, some mutual fund firms contract out to or are themselves private money managers. This gives you the best of both worlds: the SEC oversight of a mutual fund and access to some money managers that you may not otherwise be able to use.

You pay high fees to use these money manager’s services. One bank CEO, speaking at a banking conference about future sources of revenue growth, said private money management for the wealthy, along with the credit card business, are two “high-return, low-risk businesses” in the financial world. Knowing that you’re getting soaked with high fees like the average credit card customer shouldn’t make you feel so special about having a private money manager!

If you’re considering investing through private investment firms, make sure that you

Ask to see independently audited rates of return. Private managers’ holdings and performances aren’t subject to the same scrutiny and reporting as mutual funds are.

Check many references.

Compare the performance and costs of the private money manager with similar mutual funds in this book.

For more ideas about evaluating money managers, see the criteria for selecting mutual funds in Chapter 7.