Hedge funds' popularity in full bloom The stock boom has made more individuals eligible for the unconventional investment partnerships
September 30, 2000
The near collapse of the private investment firm Long-Term Capital Management, which seriously endangered world financial markets in 1998, did nothing to quell demand among wealthy investors for offbeat investment strategies known as hedge funds.
Assets managed by hedge funds total about $475 billion, up from $20 billion in 1990, according to Chicago-based Hedge Fund Research. The market boom of the 1990s has enlarged the number of individuals eligible and eager for hedge funds, especially in the dot-com meccas of the West Coast. The number of domestic and off-shore funds has jumped to 3,800 from 200 10 years ago.
Even if you consider unconventional investment strategies beyond your means or desires, it's useful to understand a little about the mechanics and psychology of hedge fund investing.
As we learned from the Long-Term Capital Management debacle, hedge-fund investors often march to a different drummer than the normal buy-low-sell-high pattern of owning stocks and bonds outright.
Nonetheless, trading sparked by complex hedge fund strategies—especially when they go sour—can have an immediate and confusing impact on the conventional investment climate. The bond market still has not recovered fully from the Long-Term Capital debacle.
Hedge funds are defined generally as limited partnerships of a few wealthy individuals that give professional managers far more leeway in their work than traditional mutual fund managers enjoy.
Typically, individuals must ante $250,000, $500,000 or more and possess sufficient net worth to pass regulatory muster to become a hedge fund participant.
Mark Yost of Chicago-based Intrinsic Capital Partners says one distinction between hedge fund investing and traditional investing through a mutual fund is the difference between absolute returns and relative returns.
Most mutual funds attempt to beat or at least match the return on a well-known market benchmark, such as the Standard & Poor's 500 index of stocks. The fund's performance is measured relative to the index. Even when the index is down, a mutual fund that is down less brags about its achievement.
Yost, who resigned earlier this year from mutual fund manager Wanger Asset Management to build a private investment fund business, said the goal of most hedge funds is to achieve a consistent, positive investment return greater than the return on Treasury bills, regardless of what the stock market does.
With the S&P 500 index virtually flat for the year after five years of remarkable gains, earning an absolute return better than 6 percent on Treasury bills seems a desirable goal.
Yost seeks to achieve about a 16 percent annual return over the next three years after fees, or 10 points above the T-bill return.
He buys out-of-favor small-capitalization stocks expected to experience some event—such as a takeover, a spinoff of a business unit or a substantial share repurchase—that will boost share prices.
"These events can occur any time and are not dependent on what the stock market does generally," Yost said. Beyond his event-driven investments, Yost may take part of the portfolio out of the stock market.
Indeed, avoiding dependency on the stock market or bond market is the principal feature of hedge fund investing. Most hedge fund strategies describe themselves as "market-neutral"—that is, uncorrelated to the stock market.
Yost says only about half of his portfolio's return can be explained by the stock market, compared with 100 percent correlation for an S&P 500 index fund.
"You can't eat relative returns, but you can eat absolute returns," says John McCarthy of Chicago-based Segall Bryant & Hamill.
McCarthy's firm offers a so-called fund-of-funds that has a diversified array of hedge fund managers using different styles.
Joseph Nicholas, chairman of Hedge Fund Research and author of "Market-Neutral Investing" (Bloomberg Press), emphasizes that market-neutral investing is not risk-free investing.
"You can't make money unless you take some kind of risk," he said.
But the risks of market-neutral strategies tend to be different from the ebb and flow of the stock or bond markets familiar to most investors.
A popular market-neutral strategy buys a security and sells short the same or similar security (sells borrowed shares), hoping to profit on changes in the relationship between the "long" (buy) position and "short" (sell) position.
The hoped-for gains depend on unexpected variations in the difference, or spread, between paired investment positions, not on the underlying direction of either position or the market.
The idea has worked this year. Of four major hedge fund styles tracked by Nicholas' firm, each had beaten the S&P 500 return through August, the latest period for which data are available. Event-driven strategies, for example, were up 12 percent net of fees, versus 3 percent for the S&P 500.
Hedge fund investors following market-neutral strategies, in effect, have withdrawn themselves and their money from the normal corrective mechanism of the market—"bargain hunting" when prices are falling and "taking profits" when prices are rising. They might sell when prices have fallen.
Current market conditions suggest that hedge funds are valid tools for diversifying portfolios, but certainly not a substitute for a traditional portfolio of stocks and bonds.
Unfortunately, the more popular hedge funds become, the less effective they will be as diversifyers. Imitators will dilute even the most unconventional strategy.
Moreover, the urge to compare strategies through indexes will undo their idiosyncratic advantages and infect the concept with relative performance obligations.
When Morningstar starts to track hedge funds, the party will be over.
Dumb question: Where is the "spot market" for gasoline?
Spot markets are markets where, in effect, buyers and sellers deal in commodities or securities for immediate or near-immediate delivery. The New York Stock Exchange is a spot market for stocks. At the New York Mercantile Exchange, the earliest-dated contracts for delivering gasoline are called "spot" contracts. Longer-date contracts are "futures" contracts. Some spot markets have no physical location. Buyers and sellers interact through dealers over the telephone or on-line linkages in what is commonly termed an over-the-counter market