The Smartest Way To Invest In Hedge Funds

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In this brief article, I would like to give you the benefit of my strongly held personal view on “the smartest way to invest in hedge funds” – and not only in hedge funds, but, I also believe, generally. This is a strong position which I believe I can support. If I can convince you and you take appropriate action, I am confident that you will have much greater peace of mind as an investor. (I will use U.S. statistics throughout, although the same principles apply worldwide.)

40 Years of Investing, 10 Years of Research
My conclusions are based on almost 40 years of investing, with the last ten years spent on research on various investing approaches including stocks, bonds, commodities/futures, mutual funds and hedge funds.

When I became intrigued by hedge funds in the early 1990s, I concluded intuitively, based on insufficient data, that they might well be the best way to invest. However, I could find no supporting research that gave me comfort. Nobody had done research on hedge funds with a large enough sample to provide sufficiently robust statistics. So, after hiring several colleagues, we assembled what we believed to be the world’s largest database of hedge funds at the time. And with the help of academics, we began doing research on our large sample.

Research Yields Exciting Results
Our findings convinced me beyond a doubt that, for my own portfolio, hedge funds were “the only way
to go.” Our subsequent conclusions over the years, with much larger samples, and the findings of others
in the industry, have confirmed our research results.

Since January 1988, there have been 20 quarters in which the AEMF has lost money. In nine of those quarters, hedge funds made money. In that same time period, the S&P lost money in 15 quarters. In all but one of those quarters, hedge funds did noticeably better.

Consider two different hedge funds, Hedge Fund A and Hedge Fund B. They have equal returns over
time but because they have different strategies, when one is up, the other is down and vice versa. The
returns of each fund are graphically portrayed in the chart above, along with the average return of the
two.

In this hypothetical illustration, when fund A’s returns are climbing, fund B’s returns are dropping, and
vice versa. The end result is the smooth Average line, which avoids the “roller coaster” effect of so many investments. Volatility/risk are lowered and this helps provide the investor peace of mind.

While the same principle of smoothing can apply to diversified stock portfolios, hedge funds can add a
critical ingredient – cushioning downfalls in bad markets through hedging.

How and Why Hedging Works for You
The classic form of hedging, used by the first hedge funds, was to invest in an approximately equal
number of long and short positions.

The long positions were intended to be undervalued stocks and the short positions chosen were overvalued.

In a rising market, the long positions increased more in value than did the short (or unattractive) stocks, leaving a net profit. In a falling market, the short positions, representing weak stocks, dropped more than the longs. In this last (dropping) market, the manager made more on the shorts than he lost on the longs so again, he made a profit.

The above type of classic hedge fund, with variations, is still very popular. However, a large number of hedging techniques, as well as a large variety of hedge fund strategies, have evolved over the years.

This increased variety of approaches has increased greatly the alternatives available to hedge fund managers for diversification of portfolios of hedge funds, commonly called “funds of funds.”

If we accept the compelling statistics on the superiority of hedge funds as summarized above and as shown throughout the www.expatwealth.com Web site, as well as the logic of the benefits of a well diversified fund of funds, how then do we choose appropriate hedge funds and then combine them properly in a portfolio, to achieve peace of mind?

How do you best assemble a portfolio of hedge funds? My honest answer is “use a professional;” i.e.,
invest in a FOF for which the hedge funds and strategies have been chosen by experienced professionals
and then combined by them in appropriate proportions. If this sounds self-serving, consider the
following:

• Selecting the “right” hedge fund and strategy requires a large database and an intimate knowledge of investing strategies, their advantages and potential pitfalls. Even if an 5 individual investor happens to find a large number of funds, will that selection be large enough to find the “best” hedge funds? Further, few individual investors have the knowledge and experience to evaluate the returns and risk control of individual hedge funds.

A FOF sponsored by a professional hedge fund company can provide access to highly
desirable funds not normally available to individual investors. 
Most U.S. hedge funds have only 99 slots (by law) for individual investors. The best funds often are closed to new investors either because they are almost full or are full. However, a few slots do open from time to time when individual investors withdraw their money for personal financial needs, including death. These rare slots often are reserved by the manager for friends in the
industry, including hedge fund companies which refer investors. If these companies sponsor
FOFs, their clients have access to those extraordinary managers. A hedge fund sometimes closes to new investors because the manager believes its size is close to effective capacity. Here again, the manager may accommodate fellow professionals.

• Selecting a hedge fund should involve very extensive due diligence – both at the outset and
ongoing. That due diligence is both too time-consuming for individuals and, as well, is highly
specialized and beyond the knowledge of the vast majority of investors. 
It is important to note that hedge funds are “unregulated” or “exempt” securities. They are subject to far fewer regulations and much less scrutiny by the Securities and Exchange Commission (“SEC”) than mutual funds. As the number of hedge funds continues to grow, the instances of mistakes and even outright fraud by the occasional hedge fund manager will
continue to increase. Fortunately, only a few instances of fraud occur each year. However, some managers, while not committing fraud, do not consistently exercise good risk control, nor do others stay with their stated investing mandate. All of these situations can cause significant earnings problems.

There are more potential mishaps than can practically be listed here – mishaps that the experienced professional can avoid but the individual investor usually cannot – either because of lack of time or in-depth knowledge.

We estimate that VHFA’s initial due diligence on a single new manager takes about three to four
full-time person-weeks; continuing monthly professional due diligence also takes a significant
amount of time.

• Creating an optimum grouping of hedge funds requires an in-depth insight into the
potential behavior of each hedge fund strategy in differing market conditions. 
The typical investor doesn’t have sufficient knowledge of hedge fund investing strategies to know how that strategy will perform in future market conditions. The manager may have had a good record to date, but his strategy could be “an accident waiting to happen” in certain market conditions. VHFA attempts to avoid certain strategies entirely, due to their inherent risks. But these strategies still find many clients….

• A professionally constructed FOF can offer a turn-key hedge fund portfolio for the same
initial investment required by a single hedge fund. 
Typically, a single hedge fund will require
a minimum investment of $250,000 to $1 million. For the same amount, you can get into a FOF.

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