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Hedge Funds For
Dummies
by Ann C. Logue
Sample pages
Introduction
You’ve seen the headlines in the
financial press. You’ve heard the rumors
about mythical investment funds that
make money no matter what happens in the
market. And you want a part of that
action.
I have to be upfront: Hedge funds aren’t
newfangled mutual funds, and they aren’t
for everyone. They’re private
partnerships that pursue high finance.
If you don’t mind a little risk, you can
net some high returns for your
portfolio. However, you have to meet
strict limits put in place by the
Securities and Exchange Commission —
namely that you have a net worth of at
least $1 million or an annual income of
$200,000 ($300,000 with a spouse). Most
hedge-fund investors are institutions,
like pensions, foundations, and
endowments; if you work for an
institution, you definitely need to know
about hedge funds. I also have to let
you in on a little secret: Not all hedge
fund mangers are performing financial
alchemy. Many of the techniques they use
are available to any investor who wants
to increase return relative to the
amount of risk taken.
Hedge Funds For Dummies tells you what
you need to know, whether you want to
research an investment in hedge funds
for yourself or for a pension, an
endowment, or a foundation. I also give
you information about investment
theories and practices that apply to
other types of investments so you can
expand your portfolio. Even if you
decide that hedge funds aren’t for you,
you can increase the return and reduce
the risk in your portfolio by using some
of the same techniques that hedge fund
managers use. After all, not everything
fund managers do requires a PhD in
applied finance, and not everything in
the world of investing is expensive,
difficult, and inaccessible.
About This Book
First, let me tell you what this book is
not: It is not a textbook, and it is not
a guide for professional investors. You
can find several of those books on the
market already, and they are fabulous in
their own right. But they can be dry,
and they assume that readers have plenty
of underlying knowledge.
This book is designed to be simple. It
assumes that you don’t know much about
hedge funds, but that you’re a smart
person who needs or wants to know about
them. I require no calculus or
statistics prerequisite; I just give you
straightforward explanations of what you
need to know to understand how hedge
funds are structured, the different
investment styles that hedge fund
managers use, and how you can check out
a fund before you invest. And if you
still want to read the textbooks, I list
a few in the Appendix.
Conventions Used in This Book
I’ll start with the basics. I put
important words that I define in italic
font. I often bold the key words of
bulleted or numbered lists to bring the
important ideas to your attention. And I
place all Web addresses in monofont for
easy access.
I’ve thrown some investment theory into
this book. You don’t need to know this
information to invest in hedge funds,
but I think it’s helpful to know what
people are thinking when they set up a
portfolio. I also make an effort to
introduce you to some technical terms
that will come up in the investment
world. I don’t want you to be caught
short in a meeting where a fund manager
talks about generating alpha through a
multifactorial arbitrage model that
includes behavioral parameters. Many
hedge fund managers are MBAs or even
PhDs, and two notorious ones have Nobel
Prizes. Folks in the business really do
talk this way! (To alert you to these
topics, I often place them under
Technical Stuff icons; see the section
“Icons Used in This Book.”)
During printing of this book, some of
the Web addresses may have broken across
two lines of text. If you come across
such an address, rest assured that I
haven’t put in any extra characters
(such as hyphens) to indicate the break.
When using a broken Web address, type in
exactly what you see on the page,
pretending as though the line break
doesn’t exist.
What You’re Not to Read
I include sidebars in the book that you
don’t need to read in order to follow
the chapter text. With that stated,
though, I do encourage you to go back
and read through the material when you
have the time. Many of the sidebars
contain practice examples that help you
get a better idea of how some of the
investment concepts work.
You can also skip the text marked with a
Technical Stuff icon, but see the
previous section for an explanation of
why you may not want to skim over this
material.
Foolish Assumptions
The format of this masterpiece requires
me to make some assumptions about you,
the reader. I assume that you’re someone
who needs to know a lot about hedge
funds in a short period of time. You may
be a staff member or director at a large
pension, foundation, or endowment fund,
and you may need to invest in hedge
funds in order to do your job well, even
if you aren’t a financial person. I
assume that you’re someone who has
plenty of money to invest (whether it’s
yours or not) and who could benefit from
the risk-reduction strategies that many
hedge funds use. Maybe you’ve inherited
your money, earned it as an athlete or
performer, gained it when you sold a
company, or otherwise came into a nice
portfolio without a strong investment
background.
I also assume that you have some
understanding of the basics of investing
- that you know what mutual funds and
brokerage accounts are, for example. If
you don’t feel comfortable with the
basic information, you should check out
Investing For Dummies or Mutual Funds
For Dummies, both by Eric Tyson.
(Calculus and statistics may not be
prerequisites, but that doesn’t mean I
don’t have any!)
And if you don’t have a lot of money, I
want you to discover plenty of
information from this book so that
you’ll have it at the ready someday. For
now, you can structure your portfolio to
minimize risk and maximize return with
the tools that I provide in this book.
You can find more strategies than you
may know.
How This Book Is Organized
Hedge Funds For Dummies is sorted into
parts so that you can find what you need
to know quickly. The following sections
break down the structure of this book.
Part I: What Is a Hedge Fund,
Anyway?
The first part describes what hedge
funds are, explains how managers
structure them, and gives you a little
history on their development. It also
covers the nuts and bolts of SEC
regulation and the process of buying
into a hedge fund. Go here for the
basics.
Part II: Determining Whether Hedge
Funds Are Right for You
In this part, I cover many investment
considerations — including your time
horizon, your liquidity needs, taxes,
and other special needs you may have -
in order to help you figure out if you
should be in a hedge fund. If you decide
against it, the information here may
give you some ideas on other ways you
can invest your money. All investors
face a list of goals for their money as
well as a series of constraints that
they must meet. The art of investing is
balancing your investment objectives
with constraints so that your money
works the way you need it to.
Part III: Setting Up Your Hedge
Fund Investment Strategy
Part III is the fun part — an overview
of the many different ways that a hedge
fund manager can generate a big return
while keeping investment risk under
control. Fund managers can buy and sell,
take big risks, or rely on arbitrage;
become shareholder activists or trade
anonymously; or speculate on interest
rates, currencies, or pork bellies.
This part also covers ways you can
evaluate a hedge fund’s risk-adjusted
performance. You’ve probably heard of a
handful of headline-grabbing hedgefund
scams, and you can find plenty of
investors who have learned the hard way
just how much risk their hedge funds
had.
Part IV: Special Considerations
Regarding Hedge Funds
Part IV covers some additional
information that you need to know,
including
alternatives to hedge funds for smaller
investors. It also tells you how to get
4 Hedge Funds For Dummies
help with your investment and how to
check out the background of the fund
and fund manager before you invest. My
goal is to help you do the right thing
with your money, and this section helps
you make the decisions that will
achieve this goal.
Part V: The Part of Tens
In this For Dummies-only part, you get
to enjoy some top 10 lists. I present
10 reasons to invest in hedge funds, 10
reasons to avoid them, and 10 myths
about the hedge-fund business. I also
include an Appendix full of references
so that you can get more information if
you desire.
Icons Used in This Book
You’ll see five icons scattered around
the margins of the text. Each icon
points to information you should know or
may find interesting about hedge funds.
They go as follows:
 This
icon notes something you should keep in
mind about hedge-fund investing. It may
refer to something I’ve already covered
in the book, or it may highlight
something you need to know for future
investing decisions.
 Tip
information tells you how to invest a
little better, a little smarter, a
little more efficiently. The information
can help you ask better questions of
your hedge fund manager or make smarter
moves with your money.
 I’ve
included nothing in this book that can
cause death or bodily harm, as far as I
can figure out, but plenty of things in
the world of hedge funds can cause you
to make expensive mistakes. These points
help you avoid big problems.
 I
put the boring (but sometimes helpful)
academic stuff here. I even throw in a
few equations. By reading this material,
you get the detailed information behind
the investment theories, some
interesting trivia, or some background
information.
Where to Go from Here
Well, open up the book and get going!
Allow me to give you some ideas. You may
want to start with Chapter 1 if you know
nothing about hedge funds so you can get
a good sense of what I’m talking about.
If you need to set up your investment
objectives, look at Chapters 7, 8, and
9. If you want to know what hedge fund
managers are doing with your money, turn
to Chapters 10 through 13. And if you’re
about to buy into a hedge fund, go
straight to Chapter 18 so that you can
start your due diligence.
If you aren’t a big enough investor for
hedge funds but hope to be some day,
start with chapters 5, 6, and 9 to
discover more about structuring
portfolios. Chapter 16 can help you meet
your investment objectives as a small
investor.
Part I
What Is a Hedge Fund, Anyway?
*****
In this part . . .You read about hedge
funds in the financial press. You hear
about their ability to generate good
returns in all market cycles. And you
wonder - just what is this investment?
In this part, you find out. Part I
covers definitions and descriptions you
hear in the hedge fund world, offers the
basics on just how much regulatory
oversight hedge funds have, and lets you
know how to buy into a hedge fund.
*****
Chapter 1
What People Talk About When
They Talk About Hedge Funds
*****
In This Chapter
* Knowing the long and short of hedge
funds
* Discovering the history of hedge funds
* Factoring a fund’s position on alpha
into your investment decision
* Distinguishing between absolute-return
funds and directional funds
* Acquainting yourself with the
important hedge-fund players
* Perusing the fee structure of hedge
funds
*****
Is a hedge fund a surefire way to
expand your wealth or a scam that will
surely rip you off? Is it a newfangled
mutual fund or a scheme for raiding
corporations and ripping off
hard-working employees? You see hedge
funds in the news all the time, but it’s
hard to know exactly what they are.
That’s because, at its essence, a hedge
fund is a bit of a mystery. A hedge fund
is a lightly regulated investment
partnership that invests in a range of
securities in an attempt to increase
expected return while reducing risk. And
that can mean just about anything.
Some of the smartest money managers on
Wall Street have started their own hedge
funds, attracted by the freedom to
manage money as they see fit while
raking in good money for themselves and
their investors in the process. Hedge
fund managers today take on the roles of
risk managers, investment bankers,
venture capitalists, and currency
speculators, and they affect discussions
in boardrooms at brokerage firms,
corporations, and central banks all over
the world.
In this chapter, I cover the basic
vocabulary and structure of hedge funds.
Having this knowledge helps you
understand hedge funds so that you can
figure out what you need to know in
order to make the best decisions with
your money. Also, I clarify what a hedge
fund is and what it isn’t, which is
important because you come across a lot
of myth and misinformation out there.
The information you find here serves as
a springboard for the topics I introduce
throughout the rest of the book, so get
ready to dive in.
Defining Hedge Funds (Or Should
I Say Explaining Hedge Funds?)
Here’s the first thing you should know
about hedge funds: They have no clear
identity or definition. In the
investment world, “I run a hedge fund”
has the same meaning as “I’m a
consultant” in the rest of the business
world. The speaker may be managing money
and making millions, or she may want a
socially acceptable reason for not
having a real job. The person who really
manages money may go about her business
in any number of ways, from highly
conservative investing to wildly
aggressive risk taking. She may be
beating the market handily, or she may
be barely squeaking by.
I’m
not trying to say that the term “hedge
fund” means nothing. Here’s the short
answer: A hedge fund is a lightly
regulated investment partnership that
uses a range of investment techniques
and invests in a wide array of assets to
generate a higher return for a given
level of risk than what’s expected of
normal investments. In many cases, but
hardly all, hedge funds are managed to
generate a consistent level of return,
regardless of what the market does.
Before I get to the longer, more
complicated explanation of hedge funds,
however, it helps to know exactly what
hedging is.
Hedging: The heart of the
hedge-fund matter
Hedging means reducing risk, which is
what many hedge funds are designed to
do. Maybe you’ve hedged a risky bet with
a friend before by making a conservative
bet on the side. But a hedge fund
manager doesn’t reduce risk by investing
in conservative assets. Although risk is
usually a function of return (the higher
the risk, the higher the return), a
hedge fund manager has ways to reduce
risk without cutting into investment
income. She can look for ways to get rid
of some risks while taking on others
with an expected good return, often by
using sophisticated techniques. For
example, a fund manager can take
stock-market risk out of the fund’s
portfolio by selling stock index futures
(see Chapter 5). Or she can increase her
return from a relatively low-risk
investment by borrowing money, known as
leveraging (see Chapter 11). If you’re
interested in investing in hedge funds,
you need to know how the fund managers
are making money.
Risk remains, no matter the hedge-fund
strategy, however. Some hedge funds
generate extraordinary returns for their
investors, but some don’t. In 2005, the
Credit Suisse/Tremont Hedge Fund Index —
a leading measure of hedge-fund
performance (www.hedgeindex.com/hedgeindex/en/default.aspx)
— reported that the average hedge-fund
return for the year was 7.61 percent.
The NASDAQ Composite Index (www.nasdaq.com)
returned only 1.37 percent for the same
period, but the Morgan Stanley Capital
International World Index (www.mscibarra.com)
was up 10.02 percent. The amount of
potential return makes hedge funds more
than worthwhile in the minds of many
accredited and qualified investors (see
Chapter 2 for more on hedge-fund
requirements).
In
2005, 9,000 hedge funds managed a total
of $1 trillion dollars, according to
Hedge Fund Research, a firm that tracks
the hedge-fund industry (www.hedgefundresearch.com).
In 2005, therefore, the average fund had
$111 million in assets. Given the
industry’s standard fee structure, in
which managers charge at least 1 or 2
percent of assets (see Chapter 2), the
typical fund generated $1.1 to $2.2
million on the year for the fund
manager.
Return
is a function of risk. The challenge for
the hedge fund manager is to eliminate
some risk while gaining return on
investments - not a simple task, which
is why hedge fund managers get paid
handsomely if they succeed. (For more on
risk and return, check out Chapter 6.)
Identifying hedge funds:
The long explanation
Okay, I’ll go ahead and start covering
the gory details of hedge funds. A hedge
fund is a private partnership that
operates with little to no SEC
regulation (see Chapter 3). A hedge fund
differs from so-called “real money” —
traditional investment accounts like
mutual funds, pensions, and endowments —
because it has more freedom to pursue
different investment strategies. In some
cases, these unique strategies can lead
to huge gains while the traditional
market measures languish. The following
sections dig deeper into the
characteristics of hedge funds, as well
as the bonuses that come with funds and
the possibility of bias in the reported
performances of funds.
Little to no regulatory oversight
Hedge funds don’t have to register with
the U.S. Securities and Exchange
Commission (SEC). The funds and their
managers also aren’t required to
register with the National Association
of Securities Dealers (NASD) or the
Commodity Futures Trading Commission,
the major self-regulatory bodies in the
investment business. However, many funds
register with these bodies anyway,
choosing to give investors peace of mind
and many protections otherwise not
afforded to them (not including
protection from losing money, of
course). Whether registered or not,
hedge funds can’t commit fraud, engage
in insider trading, or otherwise violate
the laws of the land.
In order to stay free of the yoke of
strict regulation, hedge funds agree to
accept money only from accredited or
qualified investors. Accredited
investors are individuals with a net
worth of at least $1 million or an
annual income of $200,000 ($300,000 for
a married couple; see Chapter 2 for more
information). Qualified investors are
individuals, trust accounts, or
institutional funds with at least $5
million in investable assets.
The reason for the high-net-worth
requirement is that regulators believe
people with plenty of money generally
understand investment risks and returns
better than the average person, and
accredited investors can afford to lose
money if their investments don’t work
out. In order to avoid the appearance of
improper marketing to unqualified
investors, hedge funds tend to stay away
from Web sites, and some don’t even have
listed telephone numbers. You have to
prove your accredited status before you
can see offering documents from a fund
or find out more about a fund’s
investment style.
Note: The rest of this chapter
is omitted.
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