Hedge funds are registered as private placements under Regulation D of the Securities Act of 1933 and are generally not available to the public, although some mutual funds execute hedged strategies of various types and are available to the public. The private placements are only available to accredited investors or qualified purchasers. Funds available to accredited investors, also known as 3(c)1 funds may have ninety-nine limited partners, while those available to qualified purchasers, also known as 3(c)7 funds, may have 499 limited partners. Individuals can qualify as accredited investors if their annual income exceeds $200,000 for single individuals or $300,000 for married couples filing jointly for the recent two calendar years, and the income is expected to remain at or above that level in the current year. The individual’s net worth is at least $1 million, excluding their primary residence and certain financial professionals. A qualified purchaser is defined under the Investment Company Act of 1940. To qualify as a qualified purchaser an individual must have at least $5 million in investments, and certain family-owned companies with at least $5 million in investments, or certain trusts that are not formed for the specific purpose of acquiring the securities being offered and have total assets of at least $5 million.
Hedge funds became popular in the 1990s and generally were sought by those who wanted a higher return than possible in conventional long investing in stocks. The classical hedge fund before they became popular was long and short stocks and depended on stock selection to extract a premium over the market return. The typical fee structure included an annual fee based on a percentage of the assets in the fund and an incentive allocation. Generally, the fees have been between 1% and 2% of assets for management, plus 20% of the profits after the management fee, usually after attaining a recovery to the latest high value or “high-water mark,” should the fund decline. The fee and incentive structure of hedge funds attracted many sponsors and investors with the promise of a predictable return stream. That the basic structure has persisted, albeit with management fees often being reduced as well as the incentive allocation of 20%, is notable.
Hedge Funds Can be Fee Machines
The term “hedge fund” has been applied to many vehicles that have basically the same legal structure and fee terms. No two hedge funds that I have seen execute the same strategy, although there are many that are nominally similar. The fee structure for hedge funds as described above has two components: a management fee of 1% to 2% and sometimes higher, plus incentive compensation for gains produced of usually 20%. The fees are an accident of history and are common in the industry, although have been reduced somewhat in recent years. Most hedge funds do not charge incentive compensation fees until an account balance recovers any depreciation or exceeds the so-called high-water mark. The more desirable fee structure is of course lower management and incentive fees, but most importantly has a hurdle rate below which the hedge fund gets no incentive compensation. The hurdle rate may be an absolute number like 10% or the S&P 500 return for the year for which the incentive is calculated. Most hedge funds have no hurdle rate which means that they receive the incentive or performance-based compensation annually for any return after the management fee is charged. Let us assume that the gross return is 10% and the management fee is 1%, with a 20% performance or incentive fee. The gross is reduced by 1% to 9%, and the 20% is charged to the 9% return, or 1.8% of the increase in the investor balance from the prior period, which in most cases is one year. The manager gets 2.8% of the investor’s account in fees, so the investor has a net return of 7.2%. Another way to look at this is that the manager gets 28% of the gross or before the management fee and incentive fee return, and the investor gets 72%. The fees move beyond tolerably reasonable when the gross return is less and there is no hurdle rate above which the manager is entitled to incentive compensation of 20% in this example. If the gross return is only 6% the manager gets 1% in management fees and 20% of 5.0%, or 1.0% in incentive compensation, for a total of 2.0%, leaving the investor with a net return of 4.0%. In this example, the manager receives 33% of the gross return of 6% in fees and incentive payments. When hedge funds perform well above 10% gross return a year the fees may not appear to be too high, but when below they are difficult to justify.
Many hedge funds did not perform well in the market decline from March 2000 to October 2002, otherwise known as the Dot Com Crash. This caused fund sponsors and investors to gravitate towards lower-risk hedged strategies, which did not capture the gains registered by the S&P 500 from October 2002 to October 2007, when the Great Financial Crises began to manifest in stock price declines. There were and are hedged funds that performed consistently well and delivered better than S&P 500 rates of return from March 2000 to October 2007 and beyond, but if they continue to operate many have been closed to new investors for years.
There is still an active investor interest in hedged strategies, despite the unfavorable fee structure and below S&P 500 performance for many. Hedge fund selection is an especially challenging endeavor but can be very rewarding for those whose due diligence and acumen are superior. Unfortunately, all too often hedge funds disappoint and their terms often prohibit liquidation for a year or more if they are “gated” by the general partner. “Gating” is when the general partner suspends redemption privileges. It is important to remember that the general partner(s) of a hedge fund typically have very broad discretion, and they are not generally transparent, so trust is essential. It is important to note that as recounted elsewhere in the book is the Bernie Madoff fraud. Madoff did not manage a hedge fund but maintained individual accounts for his investors that proved to be completely fabricated. In general, if a potential investor cannot meet the general partner(s) of a hedge fund to take that person’s measure, they should avoid investing in that fund. Or at least that was my rule.
There are so-called market-neutral strategies that maintain roughly similar allocations to short positions and long positions of stocks typically in the same industries, hoping to profit from anomalies in pricing due to competitive business prospects for portfolio constituents. Often such strategies use significant leverage to increase the impact of successful positions, but leverage is a very sharp two-edged sword. There is little room for error and leverage may mean that a decline in the value of collateral leads to margin calls and essentially forced liquidation of a position. One experienced investor described market-neutral strategies as running in front of a freight train picking up nickels. One obviously cannot stumble and fall. Market-neutral funds have generally not been a good place to invest relative to short to intermediate-term US Treasury security allocations. If a manager can demonstrate a persistent ability to extract a premium from pricing anomalies using market-neutral positioning great, but in many years of hedge fund research, I have found that their records were at best spotty. The promise of making money no matter what the market direction is enticing, but not so easy in practice, especially compared to relatively safe short to intermediate term US Treasury notes.
Beware of strategies that use index funds to hedge individual stock positions, because the correlation of the stock to an index may not be sufficiently high to provide the desired hedge. In other words, the stock and the index may not trade in the same direction to the same degree at the same time, therefore providing no or limited hedge. Index allocations in a hedge fund reflect a low conviction position. Hedge funds should have high conviction in their research and security selection. It is important for investors to understand risk management in hedged, long, and short portfolios because as described above the risk of shorting is asymmetrical.
Leveraged Investing and Options
I do not address options or other forms of leveraged investing and hedging, such as capital structure arbitrage, statistical arbitrage, and merger arbitrage that often require significant leverage, as I do not believe that they are necessary for long-term success in a more conventional stock and bond strategy. Moreover, although owning options has finite risk, determining the right price to pay for either call or put options can be very difficult. Some advisors advocate writing call options against existing long stock positions to generate income, but this presents the risk that if the stock does well during the option term, the stock can be called away from the investor and defeats the purpose of long-term investing. The investor may also have to pay a tax on the gains from such sales.
Alternative Investments
Alternative investments or “alts” became a popular category as hedge funds gained in popularity after the Great Financial Crisis. The point is that they are seen as deriving their returns from sufficiently diverse sources than publicly traded equities and bonds. Therefore, it is believed their correlation to the core portfolio of most funds that are comprised of unhedged equity can be efficiently diversified by investment in “alts.” Correlation is a measure of the frequency and extent of how one security, in this case, behaves relative to another. A low correlation measure, or coefficient, is considered desirable when one is structuring a portfolio because it reduces volatility, which is a salutary factor and can produce a higher risk-adjusted rate of return. Modern Portfolio Theory rests largely upon combining securities with low correlation to produce higher risk-adjusted returns, and although non-intuitive, works well when portfolio constituents behave as expected. Bonds, for example, have had a historical correlation to stocks that is relatively low, thus they have been very efficient as a diversifying component for the equity allocation. Although that correlation may vary and not produce the benefit sought, as in 2022 when bonds declined almost as much as stocks, investment-grade bonds have been a solid diversifier to stocks.
Alternatives include hedge funds of all types, real estate, commodities, private credit, distressed credit, and private equity at all stages from angel investment funds to buyout funds. There is a mutual fund category for so-called alternatives, but most are available only in private placement funds for accredited investors and qualified purchasers as described above in the Hedge Fund paragraphs.
Individual investors who are not accredited investors or qualified purchasers may participate in private equity and credit by investing in publicly traded companies that in turn invest in private equity and credit. Investments in such company stocks are liquid and reflect the acumen of the corporations that invest so represent a proxy for private investments. There are relatively few publicly traded surrogates that invest primarily in private equity or debt/credit opportunities.
Private equity and credit funds have been extremely popular among institutional investors. Private equity benefited from historically low interest rates in the years after the Great Financial Crisis of 2008-2009, but since the Federal Reserve began raising interest rates in March 2022 the prospective returns from such funds have been impaired. Private credit funds have become popular due to the demand for non-bank loans. Both types of private funds are most often only available to accredited investors or qualified purchasers, usually in the form of limited partnerships. Both also have been difficult to value, and the practical fact is that their values are reported with a lag from valuations in publicly traded securities, although they are impacted by market valuations of publicly traded securities. Such valuation dynamics have seemingly benefited the performance of investors, at least temporarily, in such funds after public markets decline. One cannot know exactly what one earned until the final distributions are made from such funds, as they typically have terms that can be, and often are, extended. Typical initial terms are for ten years, although successful funds may make final distributions before the initial term of the partnership. The other factor that investors should bear in mind is that their terms provide for capital calls as determined by the respective general partners. Investors subscribe to a fixed commitment and must meet capital calls in a timely manner or may be subject to penalties or forfeiture of their capital accounts. This has presented a problem when public equity markets decline substantially, as occurred in 2008. Declines in publicly traded equities have increased the committed allocations to private equity funds, perhaps beyond an investor’s intended parameters.
The other dynamic of private equity funds is that the general partners have very broad discretion and can extend fund termination dates to continue to manage their portfolio companies and collect management fees in the process. Unlike the initial period during which the funds charge fees based on the committed capital, after several years they charge based on asset that are invested, although there are likely more capital calls to be made to fund future investments or follow-on investments in portfolio companies.
Real Estate Investment Trusts (REITs) are another vehicle available to individual investors to participate in companies that distribute a significant portion of their earnings in dividends. They may track private investments in real estate over time and generally are interest rate sensitive, which means that their publicly traded prices tend to decline as interest rates increase. Allocations to REITs can provide diversification to equity index funds as well as generally higher dividend yields.
Master Limited Partnerships (“MLPs”) may also be publicly traded and derive their income from rents, royalties or other forms of recurring and predictable revenue. MLPs became very attractive as interest rates declined after 2009 and produced handsome returns until interest began to rise materially. They declined significantly as interest rose.
ANDREW PARRILLO
VICTORY ROAD ADVISORS LLC
617-233-9586
adp@victoryroad.com
