Hedge Funds For Dummies®
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Library of Congress Control Number: 2006932689
ISBN-13: 978-0-470-04927-3
ISBN-10: 0-470-04927-8
Manufactured in the United States of America
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Ann C. Logue is a freelance writer and consulting analyst. She has written for Barron’s, the New York Times, Newsweek Japan, Compliance Week, and the International Monetary Fund. She’s a lecturer at the Liautaud Graduate School of Business at the University of Illinois at Chicago. Her current career follows 12 years of experience as an investment analyst. She has a BA from Northwestern University, an MBA from the University of Chicago, and she holds the Chartered Financial Analyst designation.
To Rik and Andrew, for their love and support.
So many wonderful people helped me with this book! I talked to many hedge fund managers and others in the investment business, including Cliff Asness, Catherine Cooper, Beth Cotner, Nancy Fallon-Houle, Marshall Greenwald, Steve Gregornik, Anil Joshi of NuFact, Russ Kuhns, Alecia Licata of the CFA Institute, Dan Orlow, Tino Sellitto, Lisa Springer, Ryan Tagal at Morningstar, Scott Takemoto, and Gary Tilkin and Kelly Quintanilla at Global Forex Trading. I also talked to a handful of other hedge fund managers who asked to remain anonymous; they know who they are, and I hope they also know how much I appreciate their help. The CFA Society of Chicago put on a great conference entitled “New Considerations in the Quest for Alpha”, which took place in the middle of writing this book and gave me some valuable insights. I’m grateful to the volunteers and presenters who made the day so productive for me.
I want to thank a few friends who helped give me direction on writing this and who pointed me to friends of theirs who work in the hedge-fund business. Bev Bennett, Lisa Duffy, Mary Richardson Graham, and Erik Sherman all were wonderful help. I also need to acknowledge Jennie Phipps, the proprietor of Freelance Success (www.freelancesuccess.com), one of the best resources out there for professional writers.
As for the mechanics of putting together the book, Natalie Harris, Stacy Kennedy, and Josh Dials of Wiley were fabulous to work with. Their patience and good humor got me through a tough schedule. Marcia Layton-Turner gets kudos for introducing me to her agent, Marilyn Allen, who became my agent and made the book possible.
Thanks, everyone!
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Title
Introduction
About This Book
Conventions Used in This Book
What You’re Not to Read
Foolish Assumptions
How This Book Is Organized
Icons Used in This Book
Where to Go from Here
Part I : What Is a Hedge Fund, Anyway?
Chapter 1: What People Talk About When They Talk About Hedge Funds
Defining Hedge Funds (Or Should I Say Explaining Hedge Funds?)
Surveying the History of Hedge Funds
Generating Alpha
Introducing Basic Types of Hedge Funds
Meeting the People in Your Hedge Fund Neighborhood
Paying Fees in a Hedge Fund
Chapter 2: Examining How Hedge Funds Are Structured
Exploring the Uneven Relationships between Fund Partners
Only Accredited or Qualified Investors Need Apply
Following the Cash Flow within a Hedge Fund
Fee, Fi, Fo, Cha Ching! Paying the Fees Associated with Hedge Funds
Dealing with the Hedge Fund Manager
Seeking Alternatives to Hedge Funds
Chapter 3: Not Just a Sleeping Aid: Analyzing SEC Registration
Getting to Know the SEC’s Stance on Registration and Regulation
Going Coastal: Avoiding the Registration Debate through Offshore Funds
Investing in a Fund without Registration
Chapter 4: How to Buy into a Hedge Fund
Using Consultants and Brokers
Marketing to and for Hedge Fund Managers
Investor, Come on Down: Pricing Funds
Purchasing Your Stake in the Fund
Signing Your Name on the Bottom Line
Part II : Determining Whether Hedge Funds Are Right for You
Chapter 5: Hedging through Research and Asset Selection
First Things First: Examining Your Asset Options
Kicking the Tires: Fundamental Research
How a Hedge Fund Puts Research Findings to Work
Chapter 6: Calculating Investment Risk and Return
Market Efficiency and You, the Hedge Fund Investor
Using the Modern (Markowitz) Portfolio Theory (MPT)
Discovering How Interest Rates Affect the Investment Climate
Investing on the Cutting Edge: Behavioral Finance
Chapter 7: You Want Your Money When? Balancing Time and Liquidity
Considering Your Cash Needs
Like Dollars through the Hourglass: Determining Your Time Horizon
Poring Over Your Principal Needs
Handling Liquidity After You Make Your Initial Investment
Chapter 8: Taxes, Responsibilities, and Other Investment Considerations
Taxing You, the Hedge Fund Investor (Hey, It’s Better than Death!)
Figuring Out Your Fiduciary Responsibility
Transparency in Hedge Funds: Rare but There
Practicing Socially Responsible Investing
Chapter 9: Fitting Hedge Funds into a Portfolio
Assaying Asset Allocations
Using Hedge Funds as an Asset Class
Viewing a Hedge Fund as an Overlay
Mixing and Matching Your Funds
Part III : Setting Up Your Hedge Fund Investment Strategy
Chapter 10: Buying Low, Selling High: Using Arbitrage in Hedge Funds
Putting Arbitrage to Good Use
Cracking Open the Arbitrageur’s Toolbox
Flipping through the Rolodex of Arbitrage Types
Chapter 11: Short-Selling, Leveraging, and Other Equity Strategies
Short-Selling versus Leveraging: A Brief Overview
Strutting in the Equity Style Show
Market Neutrality: Taking the Market out of Hedge-Fund Performance
Rebalancing a Portfolio
Long-Short Funds
Making Market Calls
Putting the Power of Leverage to Use
Chapter 12: Observing How Hedge Funds Profit from the Corporate Life Cycle
Examining the Corporate Structure (And How Hedge Funds Enter the Picture)
From Ventures to Vultures: Participating in Corporate Life Cycles
Chapter 13: Macro Funds: Looking for Global Trends
Fathoming Macroeconomics
Taking Special Issues for Macro Funds into Consideration
Widening or Narrowing Your Macro Scope
Chapter 14: But Will You Make Money? Evaluating Hedge-Fund Performance
Measuring a Hedge Fund’s Risk and Return
Benchmarks for Evaluating a Fund’s Risk and Return
Putting Risk and Return into Context with Academic Measures
Serving Yourself with a Reality Check on Hedge-Fund Returns
Hiring a Reporting Service to Track Hedge-Fund Performance
Part IV : Special Considerations Regarding Hedge Funds
Chapter 15: Hooking Onto Other Types of Hedge Funds
Multi-Strategy Funds: Pursuing a Range of Investment Strategies
Funds of Funds: Investing in a Variety of Hedge Funds
Hedge Funds by Any Other Name
Entering Mutual Funds That Hedge
Chapter 16: Using Hedge-Fund Strategies without Hedge Funds
A Diversified Portfolio Is a Hedged Portfolio
Exploring Your Expanding Asset Universe
Structuring a Hedge-Filled Portfolio
Utilizing Margin and Leverage in Your Accounts
Hedge Fund Strategies in Mutual Funds
Chapter 17: Hiring a Consultant to Help You with Hedge Funds
Who Consultants Work For
What Do Consultants Do (Besides Consult)?
Hunting for the Hedge-Fund Grail: A Qualified Consultant
Managing Conflicts of Interest
Compensating Consultants for Their Services
Hedge Funds Pay the Consultants, Too
Chapter 18: Doing Due Diligence on a Hedge Fund
Why Do Due Diligence?
Becoming Your Own Magnum, I.I.: Investment Investigator
What Are You Gonna Do When the Hedge Fund Does Due Diligence on YOU!
Knowing the Limits of Due Diligence
Part V : The Part of Tens
Chapter 19: Ten (Plus One) Big Myths about Hedge Funds
A Hedge Fund Is Like a Mutual Fund with Better Returns
Hedge Funds Are Asset Classes That Should Be in Diversified Portfolios
Alpha Is Real and Easy to Find
A Fund That Identifies an Exotic and Effective Strategy Is Set Forever
Hedge Funds Are Risky
Hedge Funds Hedge Risk
The Hedge-Fund Industry Is Secretive and Mysterious
The Hedge-Fund Industry Loves Exotic Securities
Hedge Funds Are Sure-Fire Ways to Make Money
Hedge Funds Are Only for the “Big Guys”
All Hedge Fund Managers Are Brilliant
Chapter 20: Ten Good Reasons to Invest in a Hedge Fund
Helping You Reduce Risk
Helping You Weather Market Conditions
Increasing Your Total Diversification
Increasing Your Absolute Return
Increasing Returns for Tax-Exempt Investors
Helping Smooth Out Returns
Giving You Access to Broad Asset Categories
Exploiting Market Inefficiencies Quickly
Fund Managers Tend to Be the Savviest Investors on the Street
Incentives for Hedge Fund Managers Are Aligned with Your Needs
You’ve seen the headlines in the financial press. You’ve heard the rumors about mythical investment funds that make money no matter what happens in the market. And you want a part of that action.
I have to be upfront: Hedge funds aren’t newfangled mutual funds, and they aren’t for everyone. They’re private partnerships that pursue high finance. If you don’t mind a little risk, you can net some high returns for your portfolio. However, you have to meet strict limits put in place by the Securities and Exchange Commission — namely that you have a net worth of at least $1 million or an annual income of $200,000 ($300,000 with a spouse). Most hedge-fund investors are institutions, like pensions, foundations, and endowments; if you work for an institution, you definitely need to know about hedge funds. I also have to let you in on a little secret: Not all hedge fund mangers are performing financial alchemy. Many of the techniques they use are available to any investor who wants to increase return relative to the amount of risk taken.
Hedge Funds For Dummies tells you what you need to know, whether you want to research an investment in hedge funds for yourself or for a pension, an endowment, or a foundation. I also give you information about investment theories and practices that apply to other types of investments so you can expand your portfolio. Even if you decide that hedge funds aren’t for you, you can increase the return and reduce the risk in your portfolio by using some of the same techniques that hedge fund managers use. After all, not everything fund managers do requires a PhD in applied finance, and not everything in the world of investing is expensive, difficult, and inaccessible.
First, let me tell you what this book is not: It is not a textbook, and it is not a guide for professional investors. You can find several of those books on the market already, and they are fabulous in their own right. But they can be dry, and they assume that readers have plenty of underlying knowledge.
This book is designed to be simple. It assumes that you don’t know much about hedge funds, but that you’re a smart person who needs or wants to know about them. I require no calculus or statistics prerequisite; I just give you straightforward explanations of what you need to know to understand how hedge funds are structured, the different investment styles that hedge fund managers use, and how you can check out a fund before you invest.
And if you still want to read the textbooks, I list a few in the Appendix.
I’ll start with the basics. I put important words that I define in italic font. I often bold the key words of bulleted or numbered lists to bring the important ideas to your attention. And I place all Web addresses in monofont for easy access.
I’ve thrown some investment theory into this book. You don’t need to know this information to invest in hedge funds, but I think it’s helpful to know what people are thinking when they set up a portfolio. I also make an effort to introduce you to some technical terms that will come up in the investment world. I don’t want you to be caught short in a meeting where a fund manager talks about generating alpha through a multifactorial arbitrage model that includes behavioral parameters. Many hedge fund managers are MBAs or even PhDs, and two notorious ones have Nobel Prizes. Folks in the business really do talk this way! (To alert you to these topics, I often place them under Technical Stuff icons; see the section “Icons Used in This Book.”)
During printing of this book, some of the Web addresses may have broken across two lines of text. If you come across such an address, rest assured that I haven’t put in any extra characters (such as hyphens) to indicate the break. When using a broken Web address, type in exactly what you see on the page, pretending as though the line break doesn’t exist.
I include sidebars in the book that you don’t need to read in order to follow the chapter text. With that stated, though, I do encourage you to go back and read through the material when you have the time. Many of the sidebars contain practice examples that help you get a better idea of how some of the investment concepts work.
You can also skip the text marked with a Technical Stuff icon, but see the previous section for an explanation of why you may not want to skim over this material.
The format of this masterpiece requires me to make some assumptions about you, the reader. I assume that you’re someone who needs to know a lot about hedge funds in a short period of time. You may be a staff member or director at a large pension, foundation, or endowment fund, and you may need to invest in hedge funds in order to do your job well, even if you aren’t a financial person. I assume that you’re someone who has plenty of money to invest (whether it’s yours or not) and who could benefit from the risk-reduction strategies that many hedge funds use. Maybe you’ve inherited your money, earned it as an athlete or performer, gained it when you sold a company, or otherwise came into a nice portfolio without a strong investment background.
I also assume that you have some understanding of the basics of investing — that you know what mutual funds and brokerage accounts are, for example. If you don’t feel comfortable with the basic information, you should check out Investing For Dummies or Mutual Funds For Dummies, both by Eric Tyson. (Calculus and statistics may not be prerequisites, but that doesn’t mean I don’t have any!)
No matter your situation or motives, my goal is to give you information so that you can ask smart questions, do careful research, and handle your money in order to meet your goals.
And if you don’t have a lot of money, I want you to discover plenty of information from this book so that you’ll have it at the ready someday. For now, you can structure your portfolio to minimize risk and maximize return with the tools that I provide in this book. You can find more strategies than you may know.
Hedge Funds For Dummies is sorted into parts so that you can find what you need to know quickly. The following sections break down the structure of this book.
The first part describes what hedge funds are, explains how managers structure them, and gives you a little history on their development. It also covers the nuts and bolts of SEC regulation and the process of buying into a hedge fund. Go here for the basics.
In this part, I cover many investment considerations — including your time horizon, your liquidity needs, taxes, and other special needs you may have — in order to help you figure out if you should be in a hedge fund. If you decide against it, the information here may give you some ideas on other ways you can invest your money. All investors face a list of goals for their money as well as a series of constraints that they must meet. The art of investing is balancing your investment objectives with constraints so that your money works the way you need it to.
Part III is the fun part — an overview of the many different ways that a hedge fund manager can generate a big return while keeping investment risk under control. Fund managers can buy and sell, take big risks, or rely on arbitrage; become shareholder activists or trade anonymously; or speculate on interest rates, currencies, or pork bellies.
This part also covers ways you can evaluate a hedge fund’s risk-adjusted performance. You’ve probably heard of a handful of headline-grabbing hedge-fund scams, and you can find plenty of investors who have learned the hard way just how much risk their hedge funds had.
Part IV covers some additional information that you need to know, including alternatives to hedge funds for smaller investors. It also tells you how to get help with your investment and how to check out the background of the fund and fund manager before you invest. My goal is to help you do the right thing with your money, and this section helps you make the decisions that will achieve this goal.
In this For Dummies-only part, you get to enjoy some top 10 lists. I present 10 reasons to invest in hedge funds, 10 reasons to avoid them, and 10 myths about the hedge-fund business. I also include an Appendix full of references so that you can get more information if you desire.
You’ll see five icons scattered around the margins of the text. Each icon points to information you should know or may find interesting about hedge funds. They go as follows:
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Well, open up the book and get going! Allow me to give you some ideas. You may want to start with Chapter 1 if you know nothing about hedge funds so you can get a good sense of what I’m talking about. If you need to set up your investment objectives, look at Chapters 7, 8, and 9. If you want to know what hedge fund managers are doing with your money, turn to Chapters 10 through 13. And if you’re about to buy into a hedge fund, go straight to Chapter 18 so that you can start your due diligence.
If you aren’t a big enough investor for hedge funds but hope to be some day, start with Chapters 5, 6, and 9 to discover more about structuring portfolios. Chapter 16 can help you meet your investment objectives as a small investor.
In this part . . .
Y ou read about hedge funds in the financial press. You hear about their ability to generate good returns in all market cycles. And you wonder — just what is this investment? In this part, you find out. Part I covers definitions and descriptions you hear in the hedge fund world, offers the basics on just how much regulatory oversight hedge funds have, and lets you know how to buy into a hedge fund.