Hedge Funds Demystified
Opportunities for both U.S. and non-U.S. Investors
The authors: Thomas Watts and Edward Grey, are affiliated with Watts Capital Partners, LLC, a New York City based investment management firm that advises clients globally.
Many people, when they hear the words “hedge fund,” they think of high risk, high return investments for the ultra-rich. In practice, hedge funds often aim to have lower risk than the stock and bond markets – hence the name “hedge.” Also, hedge fund strategies are available to a wide range of investors that seek to earn returns different from the stock and bond markets. This article intends to demystify hedge funds for the reader, and describe how hedge funds may help investors, both U.S. and foreign, achieve better risk-adjusted returns than they might be able to earn elsewhere.
First of all, the number one objective for most hedge fund strategies is to generate returns that are not correlated with the stock and bond markets. This makes them a complement to an investor’s portfolio invested in stocks and bonds, either directly or through mutual funds or Exchange Traded Funds (“ETFs”). Ideally, when the stock market goes up or down, the hedge fund generates a steady absolute return, or zigs when the stock market zags. This reduced correlation decreases the volatility of an investor’s portfolio and reduces the risk of major losses.
To achieve their objective of not tracking the stock or bond markets, hedge funds may adopt a wide range of strategies. So-called long-short equity hedge funds may buy some stocks (go long), while they sell other stocks (go short). Other hedge funds may invest in special types of debt. The hedge fund structure allows their managers to pursue a wide range of strategies. Other strategies include investing in the bonds of distressed companies potentially facing bankruptcy. Some hedge funds may execute trades based on complex computer algorithms to capture short-term arbitrage opportunities (“quant funds”). Others may invest in commodity futures contracts, and some in sovereign currencies.
Investing in a hedge fund is typically part of a broader portfolio allocation strategy. Some investors may allocate 10% of their portfolio to hedge funds to provide diversification from their other holdings. Higher net worth investors may allocate up to 50% of their invested capital to a diversified portfolio of hedge funds and other alternative assets. At the extreme, is the so-called Yale Model, based on the investment management strategy followed by Yale University’s endowment, which allocates most of the portfolio to alternative investments including hedge funds, private equity, real estate and other alternatives to the stock and bond markets. For most investors, a more modest allocation is appropriate as a way to boost risk-adjusted returns of their portfolio overall.
While the actual investment risk of hedge funds varies widely depending on the strategy, hedge funds often carry two other types of risk that investors should consider. First, they often are illiquid, meaning they cannot be bought and sold daily like stocks and bonds. The illiquidity may allow investors to redeem their hedge funds only quarterly, or even longer.
The second risk is that hedge funds do not have to go through the lengthy and voluminous public disclosure process of filing a prospectus with the SEC or other regulatory body. The onus of researching a hedge fund falls on the investor, or their advisor. For this reason, the U.S. SEC limits who can invest in hedge funds. For many hedge funds, only “accredited investors” may invest in a hedge fund directly. An “accredited investor” is defined pursuant to Rule 501 of Regulation D of the U.S. Securities Act of 1933. Specifically, an accredited investor, if an individual, must have earned income that exceeds $200,000 (or $300,000 if jointly with a spouse) in each of the prior two years with the expectation that it will be the same for the current year, or has a net worth of at least $1,000,000, excluding the investor’s primary home. Other hedge funds have even higher requirements that an investor be “qualified,” which means they have a minimum of $5 million in investable assets.
Along with the accredited or qualified restrictions for hedge fund investors, many hedge funds impose a minimum investment size. These restrictions often reflect the legal requirements of the hedge fund structure that limit the number of investors. Smaller funds managed by so-called emerging managers may have minimum investments as small as $50,000 or $100,000. As the funds grow, minimum investments usually rise as well. Minimums of $250,000 or $500,000 are not unusual. Large well-known hedge funds often have minimums of $1 million or more for individuals. These minimums don’t necessarily keep smaller investors from participating. Many funds can be accessed with smaller investments through so-called feeder funds or funds-of-funds, which add another layer between the investor and the underlying fund. Even with these feeder funds, the “accredited” or “qualified” restrictions still apply.
So, is there a way for investors who do not meet the “accredited” or “qualified” standard to still invest in hedge funds? It turns out that the answer is, “Yes.” In fact there are several routes for investors to access hedge fund strategies.
The first way for non-accredited investors to access hedge funds involves investing in a hedge fund that is formed outside the U.S. (offshore) or through the offshore branch of a U.S. domestic hedge fund (the so-called offshore feeder). Many U.S. hedge funds form offshore feeders to allow non-U.S. investors to participate without being subject to U.S. tax laws. It turns out, though, that the offshores are also ideal for any non-taxable U.S. investors, such as pensions, endowments, and even individuals’ IRAs.
The second way that a non-accredited investor may benefit from investing in a hedge fund is to invest in a hedge fund through a Trust of which the non-accredited investor is a beneficiary. The Trust must have assets in excess of $5 million and not be formed for the specific purpose of investing in a specific security or hedge fund. A person who is “sophisticated” with investments must direct the Trust.
The third way, and increasingly common form for non-accredited investors to invest in a hedge fund strategy is invest in a mutual fund that hires hedge fund managers to manage a separate account for the fund, or to invest in ETFs that are designed to track the performance of hedge fund strategies. These so-called “Liquid Alts” are one of the fastest growing types of investment products.
The caveat to each of these three approaches for non-accredited investors, whether U.S. or non-U.S., is, as discussed in a previous article, that the specific hedge fund is ‘suitable’ for the investor. Even if a specific hedge fund or other investment, it may not be suitable for a specific investor, given that investor’s financial circumstances or risk tolerances.
A sophisticated financial advisor may help investors evaluate whether hedge funds are suitable for their specific situation, and whether a specific hedge fund strategy meets their tolerance for risk. If an investor is “accredited”, and if specific hedge fund is suitable for the investor, then diversifying that investor’s portfolio through hedge funds may be a sound decision. If it is the case that an investor is not an “accredited investor”, but the risk tolerance and suitability provide for investment in a hedge fund as part of an overall portfolio allocation strategy, then further diversifying a portfolio through a Liquid Alt, or through an offshore offering for a non-U.S. citizen may be appropriate as well.
Nothing in this article is intended to be, nor may it be construed as, either investment or legal advice. Nothing in this article is an offer to buy or sell, or solicitation of an offer to buy or sell, any securities in any jurisdiction. Information contained in this article is considered to be accurate as of the date of publication. A professional advisor should be consulted prior to implementing any of the options presented in this article.
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