Hedge funds: When will the party end?
For some, the connotation of the word “hedge,” as in hedging your bets, implies taking actions to mitigate risk. This is definitely not the case for the hedge in hedge funds. These high-octane investment vehicles are driven very fast, on both sides of the road, and when there’s an accident, the vehicle is usually a total wreck.In a recent article in the New York Times, reporters Jenny Anderson and Riva Atlas had this take on the hedge fund: “In a way, hedge funds are to mutual funds what Evel Knievel was to weekend motorcyclists. Unlike mutual funds, which are restricted in the ways they can invest, hedge funds can use leverage (borrow), trade derivatives and bet that stocks fall, a technique called shorting.” A hedge fund is a private investment partnership that employs a variety of highly sophisticated investing techniques to enhance return in any kind of market. Traditionally, these funds required a minimum investment of $1 million. They attracted the super-wealthy and institutions who were looking for high returns and were willing, and able, to accept high risks.That’s still true today. But now, some Wall Street operators also see an increasingly large number of investors from Main Street getting itchy about investment performance. The current ho-hum returns from conventional investing are stirring up feelings among some individual investors that there must be something else out there that will make them wealthy.The poster child for what’s now called “alternative investing” – high risk-return, venture capital and commodity funds – is the hedge fund. As usual, greed and impatience tend to eventually draw a certain percentage of investors into the fast lane of investing. Their focus is on return, not risk, which obviously has the potential for some real financial tragedy. Opportunity, risks for smaller investorsAnderson and Atlas reported that 15 years ago, hedge funds had less than $40 billion under management – today that number is $1 trillion. The number of hedge fund firms has grown from 1,903 in 1999 to 3,307 in 2004. They also cite a report by Credit Suisse First Boston that says they are responsible for up to half of all the trading activity on the New York and London stock exchanges. Today, you don’t need to be a millionaire to join the hedge fund party. Investment firms and brokerages are rolling out funds of hedge funds that allow investors with as little as $25,000 to get a piece of this new action. I remember very well how, in the late 1990s, Wall Street opened up dot-com initial public offerings (IPOs) to small investors, many of whom were certifiably, irrationally exuberant. A large number of these investors got hurt when that party ended. And let’s not forget the mother of all investment parties thrown by all those companies with “tech” in their name. Investing big-time in those companies drove the Nasdaq stock index over the 5,000 mark at the turn of the century. Today, that same index is struggling to stay above 2,000, and thousands of companies in the tech sector have disappeared. Warning signalsIf you check out a brokerage firm’s disclaimers for alternative investments, here’s a sample of what you’ll find for hedge funds:- Investing in alternative investments is speculative.- Loss of all or a substantial portion of the investment may occur.- There may be no secondary market for the fund and none expected to develop.- Information regarding valuations and pricing might not exist.- Delays in tax reporting may occur.- These funds have less regulation and higher fees than mutual funds. I would suggest that the hedge fund party is probably one to which you should decline the invitation. The Investing Wisely column is written by Richard Loth, managing principal of Mentor Investing and an independent registered investment adviser. Loth can be reached at 827-5591 or email@example.com.Vail, Colorado