Monday Morning: There’s danger lurking in the hedge funds

We will be hearing a great deal about hedge funds over the next few weeks. That’s because hedge fund managers, as a group, performed far better than the stock market indexes did last year, and that fact will be trumpeted.

The Hennessee Hedge Fund Index, for example, had a return last year of 7.88% compared with declines of 9.36% for the Standard & Poor’s 500 stock index and 5.6% for the Dow Jones Industrial Average.

In fact, only four of the 22 hedge fund-style indexes that make up the overall hedge fund index had negative returns: the Emerging Markets Index, the Growth Index, the Latin America Index and the Pacific Rim Index.

Some of the hedge fund categories had extraordinary returns in a dismal year. Health care-oriented hedge funds had an average return of 62.4% last year. Short-biased hedge funds returned an average of 29.9%. Multiple-arbitrage hedge funds were up an average of 19.8%.

Even though technology stocks were hit hard last year, with the tech-heavy Nasdaq Composite Index dropping 39.7%, technology-oriented hedge funds gained 12.4%.

Financial planners and investment advisers will be fielding questions about hedge funds from more of their clients after those results are publicized. And therein lies a danger.

Few of those clients will realize that a hedge fund is very different from the ordinary mutual fund. First, it is usually very concentrated in its holdings – that is, it generally places large bets. Second, it often uses leverage to increase the size of those bets. As a result, a health care-oriented hedge fund will be far riskier than a health-care sector fund, for example. Third, the hedge fund manager shares in any gains.

When a hedge fund gets it wrong, its losses can be very large. The classic example is Long Term Capital Management, which relied on quantitative models that said that, after a certain point, the spread between certain bonds and U.S. Treasuries should narrow. Long Term Capital used leverage to place an enormous bet on that proposition.

Unfortunately, the spreads continued to widen long after the model said they should narrow, thanks in part to Russia defaulting on its debt repayments, and Long Term Capital collapsing, which cost its investors hundreds of millions of dollars.

And very often, when a hedge fund implodes, the hedge fund manager cannot remain in business long enough to have a chance of recovering and repaying the investors.

Terry L. Beneke, president of White Capital Management LLC, a family investment office in Dallas, warned at last month’s Opal Financial Group Alternative Investment conference in Palm Desert, Calif., that when you invest in a hedge fund you often also invest in the hedge fund manager’s business.

Mr. Beneke said at the conference that one of the more than 20 hedge funds and private-equity partnerships used by White Capital Management had lost almost 50% of its assets in October and November alone.

That meant the manager had to have a 100% gain on the investments before he started to get paid by clients again. The question is, can that manager afford to continue to pay his staff, and his rent, long enough to stay in business to recover? If not, the fund’s holdings will have to be sold, probably locking in the losses.

That’s what Mr. Beneke meant by his comment that you often invest in the business as well as the fund.

Luckily, most hedge funds are off limits to all but those clients with $1 million or more in investible assets.

Nevertheless, financial planners and investment advisers will have a lot of educating to do before they allow even their wealthier clients to invest significantly in hedge funds. Even then, for those clients they should probably seek out hedge fund funds-of-funds, which provide some diversification and, hopefully, less risk.

Mike Clowes is the editorial director of InvestmentNews.

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