However, if the market moves in the wrong direction, losses can also be magnified.
In the case of Long-Term Capital Management, investing nearly $30 of borrowed money for every $1 of its own assets led to disaster. When the Greenwich, Connecticut-based fund’s investments didn’t pan out, lenders demanded their money back. Long-Term Capital Management was forced to quickly sell off holdings at steep losses to make the repayments.
Or, to maintain high returns year after year, some hedge fund managers make huge bets like those that last year sunk $9 billion Amaranth Advisors, which was also based in Greenwich. The fund’s managers disastrously misjudged the natural gas futures market. At least 83 U.S. hedge funds, which at their peak managed some $35 billion, closed up shop in 2006.
Hedge funds have other drawbacks, including hefty table stakes. The standard minimum investment has long been $1 million, but the SEC recently made a recommendation to increase the minimum to $2.5 million. But even for funds that require less, investors need to be prepared to face a “lock-up period” ranging from possibly six months to five years, during which time the funds cannot be withdrawn.
The risks and the fees–not to mention the significant capital gains tax hits that cut into hedge fund returns–should give pause to ordinary investors who see hedge funds as a clever way to beat the market. “Don’t get too allured just by their cachet,” says Morningstar’s Lyons. He says the best way for the average investor to use hedge funds is as a diversifier, to protect against declines in other parts of their portfolio.
Lyons recommends, as one alternative, mutual funds that use hedge fund strategies. While those funds offer some leverage and can use strategies such as investing long and short, they don’t offer as much leverage as hedge funds. They also are a lot more liquid and don’t require a lock-up period. Plus, they are more affordable (see “Hedging Without Getting Clipped,” Moneywise, March 2006).
Edward Witherspoon, a 54-year-old retired computer field engineer in suburban Nashville, opted for that approach two years ago. As of mid-April, his stake in the Rydex Hedged Equity Fund (RYSTX) returned 7.2% over the past 12 months, versus a 14.9% return for the S&P 500. “I try to consider investments that are in line with quality, rather than get-rich type investments,” says Witherspoon.
But what’s really attractive is that the fund is more affordable than a typical hedge fund. The H-class shares that Witherspoon owns require a minimum initial investment of $2,500.
How to find the right fund
Finding a suitable hedge fund, or fund of hedge funds, on one’s own is tricky, in part because of the restrictions on advertising.
A good way to a find a fund of hedge funds is through advisers, says Mathis. If an investor wants to get into a particular hedge fund, he or she should contact the fund and ask for the names of the funds of funds that invest in it. “Almost every hedge fund worth investing in has fund of