New Breed of Hedge Fund Lowers Ante
By JEFF D. OPDYKE, Staff Reporter of THE WALL STREET JOURNAL, January 23, 2003
Hedge funds have never been more controversial. Or more popular.
Now, they are also becoming a less costly option for some individual investors. While hedge funds have long been the province of the extremely wealthy and big institutions, a new breed of them has emerged over the past year or so that allows affluent people to invest between $25,000 and $100,000. Most traditional hedge funds require minimum investments of at least $250,000 and often much more.
The new options -- such as Oppenheimer Tremont's Market Neutral Hedge Fund and Banc of America's Opportunity Strategy Fund -- work like mutual funds. But instead of spreading your investment dollars across different stocks, they spread them across different hedge funds to reduce risk and improve returns.
At the same time, the number of people whose net worth qualifies them to invest in hedge funds has risen. Almost all hedge funds are required under federal securities law to accept only investors with a minimum net worth of $1.5 million. But the explosion in wealth over the past couple of decades, particularly in home values -- which are part of the net worth calculation -- means that more than 4.6 million American households currently meet that threshold, according to market-research firm NFO WorldGroup.
Citigroup's private banking division is now increasing the exposure to hedge funds in the accounts it manages for well-heeled investors. Because fixed-income investments aren't likely to perform as well as they have recently, and because war fears and corporate-earnings concerns will likely keep stock returns muted, "hedge funds are a good potential diversifier and return enhancer," says Ted Berenblum, chief investment executive at Citigroup Private Bank.
But whether they're an appropriate investment for less affluent investors is another matter. After all, hedge funds have been at the center of some of Wall Street's most notorious blowups, including Long-Term Capital Management's collapse in 1998 after a variety of complex interest-rate bets around the globe went sour. Beacon Hill Asset Management, a big hedge fund in the mortgage-bond market, shocked investors late last year when it reported it lost 54%, or more than $400 million, because of turbulence in the bond market.
In recent months, several other funds have posted monstrous losses or closed shop. And New York Attorney General Eliot Spitzer and the enforcement staff of the Securities and Exchange Commission have been probing allegations that hedge funds could be working together behind the scenes to push around stock prices.
But money continues to pour into hedge funds -- largely because they have on average held up well amid the bear market. While much of the rest of the market plunged, an index of hedge funds monitored by Van Hedge Fund Advisors was flat last year, up 5.6% the year before, and up 11% in 2000. The result: Hedge funds now have $600 billion in assets as a group, up 25% from 1999.
Hedge funds work by using a variety of strategies to either control risk or shoot for the moon. Some pair the stocks they own against other shares they sell short, a bet that the shares will fall in value. Others use a mix of currencies or options and futures contracts to make concentrated bets. In one of the most celebrated examples of hedging, famed hedge-fund manager George Soros made $1 billion in just days betting against the British pound in 1992.
But the risks can be significant. Hedge funds operate as lightly regulated private partnerships. They don't register with the SEC and aren't required to disclose performance data to the public. "A lot of people have been running into these things without understanding what they are," says Citigroup's Mr. Berenblum.
Another potential drawback: If you need to get your money out of a hedge fund in a hurry, getting out can be tough. Many hedge funds allow investors only one or two opportunities each year to cash out.
Outside of pension funds, foundations and university endowments, hedge funds can accept just 99 investors. (The newer mutual-fund-like hedge funds don't have that limit.)
Most people find hedge funds through word of mouth because rules bar them from marketing. Other investors rely on consultants such as HedgeWorld in White Plains, N.Y., or Van Hedge Fund Advisors in Nashville, Tenn., to steer them toward appropriate hedge funds for their risk tolerance. In some cases, the consultant's fee will be picked up by the hedge fund they invest in. In other cases, you're charged about 1% of what you invest.
Unlike mutual funds, hedge funds usually charge more than just annual management and administrative fees. They typically also take a performance fee of 20% of the fund's profits as the manager's cut for picking winning investments. Mutual funds generally don't do that. If a hedge-fund manager loses money, however, the manager gets no performance fee until investors are made whole again. In practice, however, managers often just close a fund that's underwater and start a new, sister fund.
But not every hedge fund charges a performance fee. Those that don't can let in investors who don't meet the $1.5 million net worth minimum. Recently, Charles Schwab launched its Hedged Equity Fund, which has a $25,000 minimum investment and trades just like a mutual fund. It has no net-worth requirements, though the firm suggests investors have at least $250,000 in a portfolio. It operates as a so-called long-short fund, meaning it owns some stocks and short-sells others.