TCS Daily

D-I-Y Hedge Funds

By Dominic Basulto - May 18, 2006 12:00 AM

In a recent op-ed column ("Do You Really Need a Hedge Fund?") for the Wall Street Journal, former hedge fund manager Michael Steinhardt lamented the current state of the hedge fund industry. With hedge funds now being marketed to the masses and run by amateurs, it's a recipe for trouble, writes Steinhardt: "If hedge funds are so mainstream that people discuss them casually, as if they were looking for stock tips, then hedge funds have evolved into something they were not intended to be."

Of course, the upshot of that argument is that only an elite group of wealthy, sophisticated investors should be dabbling in hedge funds, leaving Joe Investor to settle for boring, vanilla investments that can be monitored while watching the latest TV reality show.

One can only wonder, then, what Steinhardt thinks of a feature article in the June 2006 issue of Kiplinger's Personal Finance, "Hedges for Everyone." According to David Landis of Kiplinger's, "a growing number of mutual funds offer nearly all of the benefits of hedge funds with none of the drawbacks. And all you need to get through the door is a minimum investment of $1,000 to $2,500." While all of these funds deploy their capital in different ways, they all share a common attribute: the desire to create relatively low-risk hedged positions for investors. In exchange for steep 2 percent annual management fees, these funds promise the Holy Grail of investing: a fund that goes up in up markets, doesn't go down in down markets, and provides a stable source of overall portfolio diversification. One financial adviser even says that some of these funds are "as boring as watching paint dry." That is, if you think double-digit investment returns are boring!

It's not only Kiplinger's that has noticed the growing trend of hedge fund strategies for the average investor: the Wall Street Journal also highlighted the growing number of mutual funds that look and act like hedge funds, even if they don't call themselves hedge funds. (Most use euphemisms such as "Long/Short" or "Global Alpha") These funds -- all from established mutual fund families such as American Century Investments and Dreyfus -- employ a number of classic hedge fund strategies, such as "shorting" stocks in the hopes of profiting from a price decline or investing in foreign currencies and financial derivatives.

This, of course, brings us back to Steinhardt, who hints that the average investor has no business playing around with foreign currencies or derivatives. As Steinhardt explained in the Wall Street Journal op-ed piece, there is simply too much "dumb money" chasing performance. Secondly, the barrier to entry for the hedge fund business is too low, resulting in too few fund managers who actually know what they're doing.

Over the past ten years, this combination has led to an overheated market, where it has become harder to find mispriced assets. At the same time, hedge fund managers are charging ever-higher fees, leading to a situation where it's almost impossible to post the kinds of superior returns hedge funds used to post a decade ago. As a result, hedge fund managers are shifting their focus from "absolute performance" (i.e. "I made 30 percent last year") to "relative performance" (i.e. "I outperformed my hedge fund peers by 2 percent last year").

As Steinhardt sees it, this explosion in hedge fund interest over the past ten years has been nothing more than a fad. In fact, in the final paragraph of his op-ed piece, he advises average retail investors to go back to their "passive investing" strategies. However, sophisticated investment strategies for the average investor are as much a fad as the Internet was a fad.

Over the past decade, hedge funds have come to represent an "investment strategy" and not a "fee structure" (2 percent upfront, plus 20 percent of any profits) or even an "asset class," as Steinhardt suggests. With more mutual funds than ever before adopting classic hedge fund strategies such as creating long-short positions or investing in financial derivatives as a source of leverage, the line between "mutual fund" and "hedge fund" is starting to blur. Steinhardt refers to hedge funds as an "asset class" and as an "industry," when, in fact, hedge funds are a "strategy."

During Steinhardt's hedge fund heyday, fewer than 500 funds dominated the industry. Now, there are nearly 10,000 funds with more than $1.5 trillion under management. As a result, hedge fund strategies have infiltrated every corner of the investment industry. Seemingly every day, retail investors are introduced to new opportunities that didn't exist 10 years ago. Heck, these opportunities -- like new "mini-futures" for playing the commodities boom -- didn't even exist 30 days ago. At one time, the average investor needed a minimum of $1 million to play in the high-stakes hedge fund world. Today, it's possible to construct a do-it-yourself hedge fund or buy an off-the-shelf hedge fund for less than $2,000. The hedge fund genie, as they say, is out of the bottle.

Dominic Basulto is the editor of the FORTUNE Business Innovation Insider blog and writes about technology, business, and finance for TCS Daily.



Mispriced and overheated?
"Over the past ten years, this combination has led to an overheated market, where it has become harder to find mispriced assets."

Does it not follow that if the market is overheated then there should be plenty of opportunities to find "mispriced assets"?

More choices are better for investors.
I wonder why there are people arrogant to know what is good for everybody. I like having the ability to let professionals use higher risk derivitives and other investments to hedge against market downturns. I think that all investors are better off as a result.

The problem is the do-gooders that think the average investor is too stupid to hire a professional hedge fund manager in addition to hiring mutual fund managers.

As for mutual funds acting like hedge funds. That is to be expected as the market turns downward and managers are trying to protect their assets against a crash in the market. As long as it is spelled out for me in the prospectus hedging is rational.

DIY Hedge fund
I'm an investment advisor and clients ask me about hedge funds frequently now. Prior to a couple of years ago, most of my clients didn't even know what they were. I tell them they are an excellent way for a money manager to get rich.

I use an asset allocation approach to investing. I guess if I was a hedge fund manager, I'd call it macro investing. I'll let you all in on a little secret. You can create a simple asset allocation plan, using index funds, that will produce hedge fund like returns and lower volatility than the stock market. My model portfolio, going back 26 years, has produced an average annual compound return of 14.45% with standard deviation of 11.2%. During that time it has produced but 4 down years, the worst of which was -5.5% in 2002. And the annual cost, if you do it yourself, is about 0.25% using index funds. And you will only need to rebalance every two years. And it only uses 4 assets. I do it for clients at 1%/year.

Hedge funds like the ones that Steihardt and Soros pioneered are not the same as the funds being created today. Those funds produced high returns and high standard deviations. If you wanted the returns you had to deal with the volaltility. The funds being created today are mostly designed to produce steady, low double digit returns with low volatility. And paying 2% plus a % of profits to get that is crazy.

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