The hedge fund dilemma…..

First of all, if you aren’t familiar with hedge funds (and only clicked this story to see exactly what all the big deal was about….) a hedge fund is an unregulated investment which buys whatever the investors agree is appropriate. In most cases, people are buying access to a manager who’s had a track record of incredible success. Initially, a hedge fund was a way to “hedge” against down markets. Now? It’s simply whatever the investor wants it to be…..

Historically, investors have had to plop down a ton of money to invest in a hedge fund. Many had downstrokes of a million or more to get access. These managers wanted to keep funds small for a reason: it’s easier to invest with a few clients and less money than it is to invest huge sums. Peter Lynch, the now-legendary former manager of Fidelity Magellan fund, complained that it became more and more difficult to invest all of the money people entrusted to him. In fact, funds sprang up that mimicked Magellan’s moves specifically to try and invest before Magellan could move their entire position into place. However, newer companies like Sliced Investing are now lowering those minimums to $20,000, which is a big shift from the past.

Why would you invest in a hedge fund vs. an exchange traded fund?

If you’ve read anything about investing, you know how difficult it is to beat the popular indexes on a consistent basis. Few do it. Why would you even try?

There are a few reasons hedge funds are popular:

Access. The few people who DO have a track record of beating the market don’t manage funds for the masses. They know how to make serious money….and they know that the serious investor will be attracted to their success. Therefore, rather than scrape by on 0.85% by managing a mutual fund, they start a hedge fund.

Tax benefits. Many hedge funds have very few investors. Because of that, you may be able to limit your tax exposure by picking a fund that trades as frequently as you wish.
Stability/Risk Management. Some hedge funds run counter to the popular financial markets. Therefore, when the market goes sideways, your hedge fund may actually make money. That is why one of the original goals of hedge funds was strong risk adjusted returns.

Prestige. How great is it to talk about your “hedge fund” at the neighbor’s cocktail party? It might not mean much to you and I, but in some circles, there’s no sense investing in products that don’t have a certain amount of flair. “Oh really? Well, my hedge fund money is all managed by Bill Smith….he’s wonderful……” (Yes, I made up the name Bill Smith.)

Returns. While I mentioned access above, there are two reasons you want the manager. Some want the prestige mentioned before, but others are looking for a job that mutual funds can’t do. If you want a strategy involving leverage, alternative investments or complex strategies, mutual funds may not be able to foot the bill. On the other hand, because hedge funds are allowed to do nearly whatever the manager chooses, investors can widen their exposure to a huge range of strategies….from derivatives to extreme leverage. Because of this, some hedge funds have posted eye-popping returns.

The Final Analysis: are Hedge Funds Worth It?

As you can imagine, the answer to this question is simple: Maybe. While that may seem like I’m hedging (especially if you skipped everything above to just cut to my thoughts), it’s the case more with hedge funds than with others.

Because bad and good managers open hedge funds, there are three considerations:

Manager. Who is the manager and what is his/her track record?

Fees. How are you going to pay for the fund, and what’s the after-fee return on investment historically.

Strategy. What is the hedge fund attempting to do and how does this fit with your overall financial plan?

While hedge funds can offer huge returns or lower risk in a portfolio, you should be careful when allocating money to these products. Even the best laid plans can go wrong, and in a hedge fund, because of the lack of outside controls, there are no mechanisms to stop a slide beyond the fund’s manager. However, with the right management and a small piece of your overall financial “pie,” hedge funds can be a worthwhile investment idea.

Disclosure: This blog post was written for Sliced Investing pursuant to a paid content arrangement I have with the company’s representatives as part of an effort to raise awareness about alternative investment options. All views expressed are entirely my own, and were not influenced or directed by Sliced Investing. You can learn more about alternative investing at SlicedInvesting.com. Learn more about this effort to raise awareness by following hashtag #Invest2015 on Twitter.

Photo: EN2008