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10:37am EDT September 28, 2005
Hedge funds used to be an investment reserved for the mega-rich, and except for an occasional headline, they operated mainly in obscurity. Those days are over. Broadening appeal has led to explosive growth and a huge impact on the markets. Since 2000, the number of hedge funds has increased 60 percent and assets under management recently surpassed $1 trillion (accounting for more than one-half of the daily volume on the New York Stock Exchange).

Hedge funds defined
Hedge funds originated in the late 1940s with the objective of profiting on market declines or advances. The use of shorting shares (betting on a stock decline) in theory protected against a downturn, thus the name hedge. The strategy has greatly expanded since then, with hedging now just one tool in the toolbox. Since these funds are largely free from regulatory oversight, basically anything goes.

There are generally three types of strategies, and all span the risk/return spectrum. Tactical strategies strive to take advantage of global market trends affected by currency/exchange rates, interest rates and other factors. An example would be a long/short position in an equity or currency. Event-driven strategies aim to profit from price imbalance tied to a specific event (i.e. merger or takeover). Arbitrage strategies exploit pricing discrepancies between closely related securities (i.e. buy a convertible bond and then bet against the underlying equity security as a hedge).

What’s causing the growth?
When the stock market is booming, there is a sense that anyone can make money, so there is less demand for hedge funds. When the outlook is less rosy, strategies that aim to profit regardless of the market direction have appeal. With large-cap stocks basically flat since 1998, investors have been drawn to alternative investments. Also, the proliferation of technology has inspired creative traders to identify new investment opportunities and develop even more complex strategies.

While return data is less reliable, hedge fund indices have been able to provide alpha (returns in excess of the broad market) in recent years. Funds are also migrating down in terms of the minimum investment size for individual investors, and a fund-of-funds approach developed to provide exposure to different strategies. In addition to high-net-worth individuals, institutions have been jumping on the bandwagon to get excess returns with lower correlation.

Investment drawbacks
Hedge funds are marked by secrecy, and given the complexity of the strategies involved, investors must inherently trust the manager in lieu of disclosure. The lack of regulations also raises potential ethical issues. Performance tracking is difficult, since the hedge fund indices are unreliable. For instance, the data is based upon self-reporting and the index data is subject to survivorship bias (underperforming funds could drop out of the index, thereby overstating index returns).

Performance reporting can be delayed, and returns for shareholders with the same manager can vary greatly. Importantly, hedge funds don’t come cheap. A common fee arrangement is 2-and-20, or two percent of assets and 20 percent of trading profits above the risk-free rate of return. After-tax returns will also be affected, given the amount of short-term trading that occurs.

The future
Some wonder if the thousands of new funds entering the market will result in a declining alpha, because there may be fewer opportunities to exploit. It could be, however, that as talented managers continue to join the hedge fund crowd, new and creative strategies will continually be developed. Regardless, if alpha can still be generated (or at least the perception of it), hedge funds will continue to grow.

Timothy C. Gehner, CFA, CFP, is a portfolio manager and shareholder of Johnson Investment Counsel Inc., one of Greater Cincinnati’s largest investment management firms. Johnson Investment Counsel manages more than $3.2 billion in assets and has been serving clients nationwide since 1965 through three divisions: Johnson Wealth Advisors, Johnson Institutional Management and Johnson Trust Co., Greater Cincinnati’s only independent trust company.