Hedge Funds - The Case For Using Them, Part I

Top hedge funds did well in 2009. But are hedge funds or hedge fund of funds good for investors? Welcome to the first of a three part examination on hedge funds that include some important lessons I've learned from clients who came to me with hedge funds as part of their portfolio.

In this part one of the series, I'll explain what a hedge fund is and state the case for using them. In part two, I'll note some of the cons in hedge funds and reach a conclusion. Finally, part three will examine the fund of funds approach -- funds that diversify to buy many hedge funds.

What is a hedge fund?
Hedge funds can mean just about anything. I happen to like the Investopedia definition which is:

An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).
Typically, a hedge fund is only open to accredited investors, which are people who either make $200,000 a year or have a net worth of one million dollars. Thus, they are like an exclusive club only open to wealthy investors.

The argument for hedge funds
The first argument for hedge funds is that they have a low correlation with the stock market. Thus, when the stock market zigs, the hedge fund part of your portfolio zags. Hedge funds provide stability to your overall portfolio.

They can accomplish the low correlation by betting against the market (selling short), using leverage to multiply returns, and do all of this with little regulation from the SEC. In fact, their strategies are limitless, in comparison to mutual funds that must stick to a framework of their stated goals.

In a 2008 paper from Credit Suisse / Tremont, several hedge fund strategies are noted:

Global Macro - Trading in a variety of economic and market conditions.
Managed Futures - Betting on commodities such as energy and agriculture.
Long-Short Equity - Selective long exposure combined with short selling.
Event Driven - Taking advantage of current events such as buying up distressed debt.
Arbitrage - Taking advantage of smaller inefficient markets.

Unfortunately these negative correlations didn't hold for 2008 and 2009 but still, according to my calculations from the Credit Suisse Hedge Fund Index, the average hedge fund loss in 2008 was 19.1%, which was about half of the loss of U.S. and international stock funds. In addition, hedge funds came back strongly in 2009 gaining back 18.6%.

Finally, hedge fund managers are only rewarded when they make money for their investors, unlike mutual fund managers which charge no matter what the returns are.

Thus, hedge funds have delivered on their promise to both diversify and provide handsome risk-adjusted returns. What worked for endowments such as Yale and Harvard, is now available for investors.

Before you take the leap
I've tried to present some of the arguments I've heard for hedge funds. Stay tuned for part two where I'll examine the cons and look a little deeper at the claims in this column. Finally, we will see in part three whether a fund of funds approach works best for hedge funds.

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Allan Roth

Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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