Hedge funds have been so successful at what they do that the big-name funds have begun opening their doors to new investors for the first time in years. But just what does a hedge fund do, and in an industry cloaked in such secrecy, who would want to invest?
Hedge funds are lightly regulated private partnerships with fund portfolios that take positions in both safe and speculative opportunities. They use alternative strategies such as selling short, arbitrage, trading options or derivatives, using leverage, investing in undervalued securities, and trading commodity and foreign exchange contracts. They cater to institutions and wealthy investors who are looking to profit in both rising and falling markets while keeping volatility down. This strategy attempts to gain "absolute returns," which look to make positive returns regardless of what the rest of the market is doing. Mutual funds, on the other hand, are content just to beat the market averages, even if that means beating a negative number.
Hedge funds are up 5.2 percent on average this year, while the S&P 500 rose 0.2 percent and the Nasdaq Composite Index fell 3 percent. There are now around 8,000 active hedge funds, which adds up to about a $1 trillion business. To put this in context, the United States' real GDP is just under $12 trillion, while the total market value of long-term corporate debt and equity securities in the U.S. is just over $25 trillion.
With the rise in new investors, hedge fund managers profit from management fees based on larger total assets, even if they don't generate great gains in their portfolios. A typical $2 billion hedge fund today charges a management fee of about 2 percent, or $40 million. However, many new funds are charging a lower management fee, which could still add up to sizable sums.
The big problem is that many - perhaps thousands - don't even report performance data to any independent database. Because of this secrecy, there is no one source for dependable hedge fund ratings. This lack of regulation and measurement can pose a serious risk to investors, as underscored by the recent collapse of Bayou Management LLC, a Connecticut hedge fund that never made a profit despite years of sunny reports to clients. They had attracted more than $300 million in investments despite numerous warning flags.
Several companies are attempting to provide the hedge fund world with a reliable source of ratings. Morningstar Inc. and Reuters Group PLC have recently begun tracking a few thousand active hedge funds and funds of funds. Sky Fund, a New Jersey-based company, rates nearly 6,000. The ratings take into account cash under management, leverage, volatility, historic returns and other criteria. Lehman Brothers Holdings Inc. also recently announced an index based on a database of nearly 5,000 hedge funds and funds of funds that report performance to HedgeFund.net.
Unfortunately, some industry watchers assert that complete and widely accepted ratings will remain out of reach until the industry becomes less opaque. "It's unfeasible that hedge funds will be rated in today's environment," says Joshua Rosenberg, president of Chicago-based Hedge Fund Research, which has a database that tracks the performance of more than 5,000 hedge funds and funds of funds. Marc Roston, senior portfolio manager of Silver Creek Capital Management (a fund of funds based in Seattle with more than $4 billion under management), says, "It's very difficult to come up with a generic methodology that's applicable to all funds."
These measurement tools are presented with the same problem that mutual funds incur: poorly performing funds that have been liquidated or merged into other funds are excluded by these measurements. Experts say this so-called "survivorship bias" inflates annual overall mutual-fund performance by more than a percentage point. Mutual funds are required to disclose performance data, but hedge funds can choose not to, so poorly performing funds probably tend to be less cooperative, while better ones might not feel the need.
Under Securities and Exchange Commission (SEC) rules, mutual funds are required to divulge lots of information, in addition to results, that research companies use in rating them. Mutual funds also make managers available so rating researchers can evaluate their strategies and risks.
A new SEC rule will require the biggest hedge-fund managers to register as investment advisers starting in February, but the industry is otherwise largely unregulated. Hedge funds usually won't reveal their complicated strategies because they don't want them copied.
Eventually, however, resistance may fade away. When Morningstar began ranking mutual funds in 1985, it encountered resistance from fund firms that didn't want to disclose any more than what they submitted to the SEC. Morningstar initially didn't have the capacity to cover all mutual funds, but eventually even poorly performing funds lobbied to be rated, because financial advisers stopped recommending unrated funds.
If the ratings companies "get big enough and they have enough influence, managers will be compelled to report to them," says Tremont President Barry Colvin. "That's just part of the evolutionary process." Let's hope that he's right, so that the $1 trillion will not be subjected to unknown risk.
