and repay the broker.
Some hedge funds also borrow money to pump up their bets. This serves to magnify results and can produce spectacular gains–as well as stomach-churning losses.
Such was the case with Long-Term Capital Management. Founded in 1994, the hedge fund racked up annualized returns of more than 40% over four years. But in 1998, it lost a staggering $4.6 billion in less than four months and finally closed two years later.
There’s one type of hedge fund that aims to generate returns that may be modest but consistent whether markets are rising or falling. Such “market-neutral” funds may buy stocks or derivatives whose prices seem likely to rise–while also borrowing and selling shares of other companies whose prices seem likely to fall.
Because of hedge funds’ limited regulation, it’s hard to find comprehensive data that assuredly represents the performance of a typical fund. Certainly there have been studies, but many findings come with caveats. For instance, How Smart are the Smart Guys?–a study by John Griffin, a finance professor at the University of Texas, and Jin Xu of Zebra Capital Management–examined the equity holdings of 306 hedge funds from 1980 to 2004 and found that there’s “weak statistical evidence that hedge funds are better at stock picking (1.32% per year) than mutual funds.” But they found that that outperformance was due largely to the tech stocks held in 1999 and 2000.
Not just for billionaires
Hedge funds have existed since at least the mid-20th century, and for most of that time they have been the province of the superrich. The emergence of mutual funds that employ hedge-like strategies shows the extent to which the idea of hedging portfolio risk has become more mainstream.
Starting in the 1980s and 1990s, hedge funds began to attract money from institutional investors who sought to hedge market risk and increase returns. Steep declines in many of their portfolios as a result of the dot-com crash only sparked further interest.
Melanie Dean, owner of Dean Financial in Nashville, Tennessee, says that about three years ago hedge fund investing began to be seen as a legitimate option for more investors. “Before that, it was considered high-risk and unscrupulous, almost like buying penny stocks,” says Dean, who adds that 17 of her 50 high-net-worth clients use hedging strategies in their portfolios.
But investors have become open to alternative investments in recent years, she says, partly because they have had to as old-school pension plans are rapidly being replaced by employee-directed alternatives such as 401(k)s. Dean counsels her clients, all of whom let her manage at least $100,000 of their money, to expose no more than 10% to 15% of their portfolios to hedging strategies.
True hedge funds remain exclusive, however, because they are available by law only to “accredited” investors–those with an income of more than $200,000 a year for individuals, or $300,000 for couples, for each of the past two years or individuals with a net worth exceeding $1 million.
In time, demands from the market led companies to open up hedge fund