Monday, November 14, 2011

Should You Invest in a Hedge Fund?

If you are an individual investor, then in my opinion, the short answer is no. The question is why should you invest in a hedge fund? It boggles my mind why people continue to want to invest in things that they cannot see, touch, feel, hear or taste. Well maybe I am going a little overboard, but most people want to invest in a hedge fund because of one of two reasons.

  1. Performance
  2. Hedging a portfolio against a shock to the market.
Number one is clearly bad. You should never and I mean never invest with anyone based on their performance. Suppose a hedge fund manager had great performance for the last year. This does not mean that they will have great performance for this year. Performance is the world's worst reason to invest with anyone.

Number two can be accomplished in other ways. You do not have to give your money to a superstar hedge fund manager (who is basically a gambler with your money) because there are now other options. Hedge fund managers take positions that they believe will be profitable in the future. Sometimes they are right and sometimes they are wrong. It is like investing in general. You can have good years and bad years.

I can show you 5 different examples to hedge an index like the S&P 500®. By the way, do not do this at home. This is not investment advice, rather educational in nature.

  1. If you believe the S&P 500® is going to go up, then you might buy 100% S&P 500® index.
  2. If you think the S&P 500® is going up, but you do not feel real strongly about it, then you could do a 130/30 long short on it. That is 130% long and 30% short the S&P 500® index.
  3. Or, if you are not sure of which way the S&P 500® is going and you just want to preserve capital, then you could go 50/50 long and short. You will not make anything nor lose much besides trading costs. Your portfolio value should stay close to where it is currently valued.
  4. If you are a bear on the S&P 500®, but not a total bear, then you could go 130/30 short long. Or 130% short and 30% long S&P 500®.
  5. If you are a real bear on the direction of the S&P 500® and firmly believe the market is going straight down, then you can go 100% short the S&P 500® index.
What is the right answer? There is no right answer.

Obviously, there is perfect timing for each of these strategies, but also significant risk to each of them if you are wrong. Hedge fund managers do more than make these type of decisions. I wanted to explain to you the various options available to them in simplistic fashion. When they invest your money, they are making a bet similar to one of these five strategies. When they are right, they are heroes. When they are wrong, they are goats.

There is more risk to investing in hedge funds than meets the eye. The SEC recently charged two Minnesota based hedge fund managers and their firm for facilitating a multi-billion dollar Ponzi scheme. (Not again.) See this link below.

Here is something that I want to get across to readers. Stay with visible, publicly traded investments. Do not fall for the sales pitch for non-publicly traded, exotic or offshore investments. Know where your assets are custodied. Compare your statement to that of your custodian. Be clear on who is managing your money. Know what a feeder fund is and how it functions. Most importantly, know what you do not know.

Stay safe out there.