Below is a weekly update from our Chief Investment Officer, Dr. Scott Lummer. He co-hosts a seven minute audio segment entitled “Market Matters.” In this week's show, Scott discusses how a hedge fund works. He talks about how their investment structure is different than mutual funds, and describes the fees that hedge funds charge. He also describes how the use of leverage in a hedge fund can add to return, but also add to the risk of the fund. Each week he covers a different piece of investment news focusing on recent events in the capital markets, and relates them to Savant Investment Group’s perspective on investing.
Daphne: My name is Daphne O’Neal, and welcome to Market Matters. This week, our topic is hedge funds, and as always, we will talk about this with the Chief Investment Officer for the Savant Investment Group, Dr. Scott Lummer. Scott, an investment I often hear about in the financial press are hedge funds. But it seems like that it is difficult to pin down precisely what a hedge fund is.
Scott: You’re correct Daphne - hedge funds come in all types of investment vehicles, and there are different definitions of what constitutes a hedge fund. Many investment entities that call themselves a hedge fund in my view are not really a hedge fund.
Daphne: What differentiates a hedge fund from a mutual fund, with which most investors are familiar.
Scott: There are three main differentiators the separate most hedge funds from mutual fund investments – the nature of the investing, the structure of the fund, and the fee structure. The nature of investing is the most important. The key aspect of the nature of investing of hedge funds lies in their name – they attempt to hedge some aspect of risk in the fund.
Daphne: How does the hedge work?
Scott: In today’s market, there are many ways to hedge some aspect of risk in a portfolio. As an
example, let’s look at a long-short strategy for stocks. A manager looks at stocks relative to each other in various industries – let’s say they believe 20 stocks are undervalued and 20 stocks in those same industries are overvalued. The manager buys the stocks that are undervalued, and short-sells the stocks that are overvalued. In theory, the manager is taking no market risk because if the market goes up or down, it should affect the purchased stocks and the short sale stocks equally. So the only return that will be earned will be if the purchased stocks outperform the short-sold stocks.
Daphne: How does that return compare to the return in a typical mutual fund?
Scott: With a typical mutual fund, you are getting two pieces of return, the market return, and the return based on the manager skill in outperforming the market. With a hedge fund, if the hedge is conducted properly, you are distilling away the market return, which leaves the pure skill portion of the return.
Daphne: That sounds logical. But I know many consider hedge funds to be riskier. Why is that the case?
Scott: When a manager creates the hedge, not only do they take away market risk, but they also can take away much of the need for capital. The manager can use most of the proceeds from the short sales to purchase the stocks. In that way, the manager is using leverage, and that leverage adds to the risk. For example, suppose a hedge fund manager raises $100 million from investors. The manager can use that money, and let’s say the $900 million in capital from short-sale positions, to buy $1 billion of stocks. So in that case the manager has used 10 times leverage in the portfolio.
Daphne: How does that leverage affect returns?
Scott: Suppose the manager is right, and the purchased stock positions outperform the short-
sold positions by an average of 5%. On $1 billion of investment, that is a profit of $50 million. But the manager only raised $100 million of capital. So that means the investors in the fund receive a profit of 50%.
Daphne: Wow – so that means the leverage helped the investors.
Scott: As long as the manager is right. Leverage is a double-edged sword. If the manager was wrong, and the purchased stocks underperformed the short-sold stocks by 5%, investors in the fund would LOSE 50% - that is the risk of leverage.
Daphne: Does a hedge fund have to use that much leverage?
Scott: No they don’t. For instance, in the example I just used, the manager could only take $500 million in long and short positions, which would reduce the amount of leverage, and the amount of risk, by half. The amount of leverage is a manager choice – indeed, the manager can choose to use no leverage.
Daphne: You mentioned that the structure of the fund is different – how so?
Scott: Mutual funds have a specific set of regulations and reporting requirements, such as allowance of withdrawals with daily notice, quarterly reporting to the SEC, restrictions on types of investments. Those requirements add to the cost of a mutual fund, and allow competitors to mimic the strategy. Hedge funds have a different set of regulations – withdrawals can be highly restricted, valuation might only be done monthly or even annually, and holdings might not ever be reported. That means a lack of liquidity and transparency for investors.
Daphne: Can any investor purchase a hedge fund?
Scott: No – because of the regulations guiding hedge funds, investors have to meet specific criteria, such as minimum wealth, income, and sophistication provisions. For example, some types of hedge funds allow investors with a minimum overall securities position of at least $1 million – other types require a minimum of at least $5 million.
Daphne: You also mentioned that hedge funds have different fee structures.
Scott: The fees for hedge funds are much higher than most mutual funds, and are typically broken out into two pieces. The first is the asset fee, which is commonly 2% of the investment,which is more than double the average fee of an equity mutual fund. Moreover, hedge funds typically charge a performance fee, which will be a certain percentage – commonly 20% -- of the profits of the fund over a certain benchmark.
Daphne: Thank you Dr. Lummer, and this concludes this week’s Market Matters broadcast. Next week we will continue the discussion of hedge funds.