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Hedge funds have a bad reputation and I have noticed that they are frequently blamed when anything goes wrong in the financial markets. While there are certainly hedge funds that are not acting in the best interest of their investors and occasionally there is a complete scam involving a hedge fund the same can be said for almost any investment class. Look at AIG and Enron. The bottom line is that investors must do their homework which includes background checks and the scrutiny of performance data and supporting documents when choosing any investment fund.
What is a hedge fund? A hedge fund is an investment fund that is allowed to invest in a broader range of investments than other types of investment funds. They are less regulated than mutual funds and are only able to have a limited number of investors. The manager usually gets paid a management fee in addition to a performance fee that is a percentage of profits above what is referred to as the “high water mark”. Hedge funds are generally only available to accredited investors who are individuals with a certain amount of income and or net worth. This allows hedge funds to be able to make more speculative and aggressive trades such as short selling and using derivative contracts. Sometimes this is a bad thing but not always. Being invested in a fund that was short selling stocks could have protected an investor’s capital over the past 18 months.
I personally know several hedge fund managers that have performed well and are people of integrity. I know of numerous hedge fund investments that have been very solid and profitable investments for well over a decade. While the fees can be high the structure of the performance fee mandates that the manager will be paid less when the fund does not perform well. How many mutual fund or private money managers have this format?
Why am I writing about hedge funds today? The weekend Barron’s had an article by Eric Uhlfelder entitled “Grabbing the Gold” which was an informative interview with Jim Melcher Chief Investment Officer of Balestra Capital a hedge fund manager that was up a cumulative 458.5% for the previous five year period. Also included was a hedge fund report card showing performance through February 27 of this year. The chart included the best and worst funds for February which do not interest me due to the short time frame however the chart also included the performance of the biggest hedge funds. Remarkably out of the 17 biggest funds that had 5 year performance numbers only 2 had negative performance for the five year period. One was down 7.2% and the other was down 40.8%. Cumulative five year returns on the remaining 15 biggest funds ranged from 11.4% to 458.5%. Granted only one fund was over 166% but four were in the well over 100% range. While these performance numbers require further research to determine how performance fares in both bull and bear markets the numbers indicate that at least some hedge funds would have been safe havens over the past five years. Now that is something to think about.
Camille’s Financial Jargon Clarifications:
Short selling refers to selling a security before buying it with the intention that the trader will buy the security when the price goes down and make a profit. Just remember that with a short sale the sale occurs before the purchase.
A financial derivative is a security that has a value tied to the value of another security. I’ll write more about this common investment concept later in the week.