Articles

Three Reasons–at Least–to Invest in Hedge Funds

By Jack Killion

Number 1: It’s a great way to have exceptional investment managers handling your self-directed IRA and non-IRA accounts. Number 2: Same as Number 1. Number 3: Same asNumbers 1 and 2. Aren’t we all looking for exceptionally talented investment professionals to help us manage our own assets?

The simple fact is that some of the very best investment managers in the world head their own successful hedge funds which they use to manage their own assets as well as assets for their investing clients. The reason this is true is because, when successful, the business model for the founder/portfolio manager is exceptional. They earn enormous fees while their own assets appreciate under their skilled direction.

But gaining access to the best of the best hedge fund managers isn’t easy unless you have $1 million or more to invest – that won’t always get you access – or if you use a fund of hedge funds that pools capital from multiple investors in order to gain access to the top hedge funds with their high minimum investment requirements.

Ten years ago the hedge fund industry had about 3500 hedge funds and was basically a U.S. dominated industry with most of the hedge funds being from the U.S. as well as the investor who, at the time, were primarily high net-worth individuals. Today there are over 14,000 hedge funds to chose from with maybe half of all funds and well over half of all invested capital coming from large institutional investors including government and private pensions, university endowments, foundations, family offices and increasingly from overseas sovereign funds.

Reasons even sophisticated investors do not use hedge funds in their portfolios are many with the main ones being: they never think to use them, they don’t understand them, their advisors never talk with them about hedge funds (often their advisor’s firms prevent them from doing so) and they don’t know how to find, evaluate and negotiate to get into the better ones.It’s a challenging industry to understand and access since regulations prevent hedge funds from marketing their funds. You can’t even get into a hedge funds website without gaining the passcode to get past the barrier. You will never see a hedge fund ad or get an unsolicited piece of mail from a hedge fund.

So, if you really have an interest in having some of the world’s best investment managers handle a portion of your IRA and non IRA portfolios, you will have to work hard at it.

Understanding Hedge Funds

There is high turnover in the hedge fund industry with hundreds of new ones starting up each year and hundreds of poorly performing ones dropping by the wayside, unable to attract and retain investors’ capital.

All hedge funds are limited to accepting investment capital only from accredited investors. There are two types of hedge funds depending on the qualifications they establish for their investor base. One type of hedge fund can have up to 100 investing limited partners. 
The second type can have up to 500 limited partner investors. So, investment slots in the best performing hedge funds are precious and managers do not want to “waste” a slot with an investor able to make a modest investment. Weird as it seems, a $1 million investment to some hedge funds is too small to be of interest when what they really want to attract is millions of capital from large endowments, pensions, family offices, foundations and fund-of-funds.

Many better performing hedge funds simply are not looking to attract new capital, although they will accept it from the right investors if it comes their way. Some of these same top performers are simply closed to new investors and sometimes even to additional contributions from existing limited partners.

For the uninitiated a comparison of hedge vs. mutual funds can be useful. Hedge funds, besides having high minimum investment requirements ($1 million or more usually) and a sharply limited number of investors:

  • Have fewer assets under management, meaning they can concentrate their capital in fewer, higher quality opportunities. That’s a good thing.
  • Often use more investing and hedging strategies to achieve higher performance with lower risk and volatility. That’s a good thing.
  • Are headed by an entrepreneurial founder who has his/her own capital invested in the hedge fund along side the limited partners. Interests are in sync. That’s a good thing and may not be true of a mutual fund portfolio manager who is generally an 
    “employee.”
  • Rely heavily on getting a piece (usually 20%) of net investor year-end gains as the bulk of their compensation. This huge incentive seldom applies in the mutual fund industry.
  • Limit investors’ liquidity by imposing lock-up periods (usually a year) with scheduled redemptions following the lock-ups. Mutual funds provide same day liquidity.
  • Hedge funds provide each investor with his or her own tax basis unlike mutual fund investors who may inherit other investor’s gains or losses for tax purposes.

The Internet has made it much easier for potential hedge fund investors to begin learning about the industry. With a little searching investors can turn up hedge fund investing conferences, books, websites such as Eureka.com and Barclays.com, and third party marketers who represent a group of non-competing hedge funds trying to attract major investors.

With a little digging investors can find examples of strong performing hedge funds. Three good examples are a merger arbitrage hedge fund based in New Jersey that has been investing with the same strategy for 37 years with only one down year (-3.0%). An event driven hedge fund in New York has had one down year (-4.0%) in 23 years while averaging +17% a year. Another fund based in New York invests only in small cap companies and over the past 7 years has averaged close to +20% per year without any losing years. These funds and hundreds of others have made many of their investors and their general partners multi-millionaires.

A fund of hedge funds, like our Eagle Rock Diversified Fund, may offer new and “relatively modest” accredited investors an efficient way to begin investing in the hedge fund sector. With a single investment from $100,000 to $250,000 an investor has someone else familiar with the industry doing the searching, due diligence and post investing monitoring. And the single investment is allocated across the fund of funds portfolio achieving immediate diversification. The biggest down side to fund of fund investing of course is that investors wind up paying two sets of management and performance incentives fees which can be justified if the fund of funds performance to expectations and meets the investor’sobjectives.

CamaPlan Academy provides an opportunity for IRA investors to learn more about hedge fund investing as an alternative to more typical forms of stock market investing.

Questions or Comments?

Jack Killion
General Partner
Eagle Rock Diversified Fund
908-507-9879
jkillion@eaglerockfund.com

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