Opening Up the Secret World of Hedge Funds

Posted by: Joel    Posted Date: Tue, 10/30/2012 - 1:20pm

Categories: International Investments

If you owned a tech sector mutual fund in recent years, you saw your portfolio lose on average 34% of its value. Compare that with a variety of technology hedge fund that posted 20% to 35% gains. The Nasdaq lost 29% of its value while hedge funds on average returned an 8% gain. In 12 out of the last 14 years, hedge funds have out performed the markets as well as the average returns for stock mutual funds.  

Hedge Funds are a World Most People Know Nothing About

Ask any savvy investor if they have ever heard of George Soros, Julian Robertson, Seth Tobias or Stan Druckenmiller, and the answer will likely be "of course." Ask those same savvy investors if they have any part of their financial portfolio in hedge funds, and you'll get a glazed stare back.  Historically, hedge funds have been a cloistered and mysterious world to most investors since they first appeared on the market back in 1949.

Hedge funds are basically private pools of capital (generally under 100 shareholders) managed by an investment manager.  Their common feature is that they have little or no external control on what they can do or how they should invest.  This gives the hedge fund manager the ultimate flexibility to earn the highest return and protect the downside risks.

Hedge Fund Managers

The investment manager, is compensated with a percentage of the profits that he earns for the fund. Stock brokers and mutual fund managers have a completely different manner of compensation.  It has to do with trading volume, benchmark indices and assets under management and very little to do with whether or not their clients make money. Hedge fund managers' interests are singularly aligned with the investor since he only earns a performance fee when he earns profits for his clients. The bigger the profit to the funds' investors, the higher the performance fee to the fund manager.

The standard performance fee is 20%, so if the fund manager earns a return to his fund of $100 million, he puts $20 million in his own pocket. If he loses $100 million for his investors, the fund manager makes nothing for the year and continues earning no performance fee until he surpasses his own previous high watermark.  In other words, he has to get you back to the most you ever had in the account before he can earn another dime.
While it can be risky business for the fund manager, the best and brightest have enough confidence in their abilities to give up the steady paycheck of the stock broker and mutual fund manager.

According to a recent Business Week article, "There's been a huge brain drain out of every corner of Wall Street into Hedge funds." To me that is especially sweet music in these turbulent financial times. As an investor, I like nothing better than to have my money invested with a professional "Hedge" fund manager who makes more and more money, the more money that he makes for me, and who conversely can't afford to let his clients lose money.

So if the best and brightest on Wall Street prefer to manage private pools of capital in these types of unregulated "hedge" fund vehicles, (which historically out perform stocks, bonds and mutual funds), why don't more people know about them?

We'll address that question, and more, in part two of this article on Thursday.

Copyright 2002 Nagel & Associates, LLC