Hedge funds, private partnerships that bet both on and
against various investments, manage more money than ever, and interest in them
remains strong. Over the past 15 years, their returns have beaten the overall
stock market, helping drive the boom. Hedge funds also navigated the 2008
downturn with smaller losses than stock mutual funds, and tend to attract the
best and brightest from Wall Street, largely because they pay top salaries.
Stocks today are expensive, and hedge funds' ability to buy
stocks, bonds and commodities is valued in challenging markets. If the Federal
Reserve begins raising interest rates next year and the market runs into
problems, hedge funds might be best positioned to take advantage.
The drawback is, only "accredited" investors are
legally allowed to invest with hedge funds because of the perceived risks. And
even if an investor vaults over this threshold, hedge funds generally charge
hefty fees of about 20% of any gains and about 2% of assets annually.
However, more options have emerged that allow even small
investors to engage in hedge-fund-style investing without big fees. Here is a
look at the advantages and risks of three of these approaches.
The closest most small investors can get to hedge-fund-like
investing is through "alternative" mutual funds. As with hedge funds,
most of the money in these newer mutual funds is in portfolios that use a
long/short investing strategy: They can both bet on individual stocks going up
(in industry parlance, "going long") and profit from others going
One advantage long/short mutual funds have over hedge funds
is transparency. While most sizable hedge funds disclose their stockholdings on
a quarterly basis, they don't share information about their short positions and
debt holdings. By contrast, long/short mutual funds must provide a public list
of quarterly positioning, along with other data. As such, investors can track a
manager's views, and decide whether they agree with them. Long/short mutual
funds also can be bought and sold on a daily basis, unlike a hedge fund.
Although these mutual funds don't charge performance fees
like hedge funds do, they collect hefty annual management fees that in some
cases approach 4% of assets. This acts as a hurdle to jump over every year, and
it creates an incentive for managers to amass ever larger piles of money to
invest, which can hurt performance.
Another fast-growing area is so new proponents can't agree
on a name. Sometimes called "replication" funds and other times
"liquid beta," these vehicles try to imitate the performance of
hedge-fund benchmarks, much like an exchanged-traded fund tries to produce the
results of an underlying index.
ETFs, however, know the components of the indexes they try
to copy. Because hedge funds keep some of their positions secret, beta funds
take a different tack: They "backtest" their portfolios of stocks,
bonds, currencies and other assets—meaning they do a simulation of a trading
strategy on prior time periods—until they approximately copy the trailing
returns of the average hedge fund as tracked by research firms like HFR.
One problem for such funds: Most successful wealthy
investors look for hedge funds that beat their peers, not match them. And if
hedge funds continue to do worse than the overall stock market, investors
betting on the broad hedge-fund sector could have regrets.
Another low-cost way to trade like a hedge-fund manager is
to ape the best-performing funds. Even top hedge funds employ this technique,
keeping a close eye on each other's holdings. The approach is fraught with
Hedge funds with portfolios of more than $100 million of
public securities must file 13F forms with the SEC in which they list a
snapshot of their largest stockholdings. (They don't have to disclose other
positions.) The forms must be filed within 45 days of the close of each
quarter, and investors can search these filings on the SEC's website. One tip:
Look for new and increased positions of top hedge-fund firms to get a sense of
the companies the funds are bullish about, along with decreased and "sold
out" positions for those the firms seem more pessimistic about
Individuals also can hop a ride on disclosures from
successful activist hedge-fund investors—who publicly prod companies to take
steps to boost their stock prices—through a vehicle such as 13D
Activist Fund. The fund combs through the 13D filings of activist investors
and bets on companies where it believes activist campaigns have the best chance
The setback with copycat investing is that the information
can be quite stale by the time it's released; 45 days can be an eternity in the
hedge-fund world. Also, funds may own shares simply as a hedge against a stock
in the same sector, or as part of other moves that don't necessarily reflect
how a manager feels about a company.
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