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10 Questions for Clients Considering Hedge Funds

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Sep 20th 2017
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It’s safe to say the stock market has done pretty well this year, but if the party ever ends your individual clients may be considering a better mousetrap. Many have fallen in love with hedge funds, but how we will you advise them?

Instead of dismissing them or entering into an adversarial role with your client, consider these 10 educational questions instead:

1. What is a Hedge Fund?

An investment partnership between a general partner and its investors, or limited partners.  The word “hedge” comes from its stated objectives to maximize returns while eliminating risk. These this is difficult when the stock market is declining, they are often called non-correlated assets.

2. Can Anyone Own a Hedge Fund?

They are restricted to qualified or accredited investors.  This usually means sophisticated investors where the potential of losing money would not ruin them.  They are also expected to ride it out for the long term.  Typically this means liquid investments of $ 1 MM+, excluding your primary residence.

3. How are Hedge Funds Different From Mutual Funds?

Mutual funds traditionally are bound by several constraints. They buy stocks and bonds.  In general they cannot go short.  They also are usually prohibited from using leverage.  Diversification is good.  Concentrated holdings are bad.

4. How do Hedge Funds Operate?

Hedge funds operate under a much more relaxed set of rules.  As mentioned earlier, they can buy long or sell short.  They can use leverage to amplify returns, although this can work both ways.  They are use derivatives. Generally speaking, they fall into eight broad categories:

  • Long-Short Funds - Also called hedged equity.  Some firms seek out undervalued stocks regardless of market conditions.  They go long.  They go short. They wait.
  • Equity Market Neutral – Markets have overvalued and undervalued securities.  They attempt to short the first and buy the second, ending up with a market neutral position.
  • Convertible Arbitrage – Convertible bonds pay interest while offering the ability to swap bonds for cash at set price.  This helps with volatility.
  • Fixed Income Arbitrage – You feel some bonds are due for an upgrade, others a downgrade. You invest accordingly, bringing the duration close to zero.
  • Distressed Securities – When firms are in trouble, few people want them.  They might decline far more than necessary, making them a good deal.
  • Merger Arbitrage – A lot can happen between the time a merger is announced and the deal is done.   Acquired companies may rise, while the company making the bid may fall.
  • Global Macro – They invest in currencies and bonds expecting a move.  This also involves futures and options contracts.
  • Emerging Markets – Not all stock market opportunities are in the developed world.

5. What Instruments Might They Buy?

The world is their oyster.  Stocks and bonds are obvious choices. Shorting lets them bet on the other side of the market.  Leverage enhances returns.  Add in futures and options.  Add in non-traditional investments like real estate.

6. How Many Hedge Funds are There?

As of September, 2016 there are about 9,925 hedge funds.  According to CNBC they control $2.979 trillion in investor assets. Clients might think there are only one or two really smart guys.  It more similar to a Roman galley with everyone pulling on the oars.

7. Do They Make Decent Money?

Again, according to CNBC, for the 11 months through November, 2016, North American funds averaged 9.09%. The rolling 12 month yield was 10.74%. The DJIA 11 month yield was about 9.75%.

8. What do They Charge?

Traditionally hedge funds charge three fees.  First, there’s a 2% annual fee on assets. That’s win or lose.  Since you are paying 2%, they often have a threshold where the first 3% in profits stays with you. 

Finally, the general partner gets 20% of the profits. Above that amount.  It’s called the “2 and 20” rule.  There’s lots of competition, so the scale has retreated to 1.49% and 17.5%. 

9. Can I Get My Money Out Any Time?

Generally, the answer is no. Lots of these investments are illiquid and might be thinly traded.  Investors often panic. Many hedge funds only allow investors to take money or quarterly dividends. Sometimes it requires 3 to 90 days advance notice.  That’s why they have net worth restrictions mentioned earlier.

10. Can I Just Get a Little Bit of Everything?

Yes. There’s “fund of funds” concept that buys across several fund types.  However, this has an additional level of fees from the firm putting the funds of funds together.

Conclusion

The major advantage of hedge funds in the non-correlated aspect.  Everyone ideally wants to make money in a declining market. This is balanced by the “customer beware” rule and the high fees involved. Can your client answer these 10 questions?  

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