The Hedge Funds Industry

RYDEX SPHINX?

Little guy gets a chance at investing in hedge funds
Posted December 12, 2003
Once limited to those who could afford to invest at least $1 million, hedge funds - private investment pools employing sophisticated, and sometimes risky, techniques in an attempt to make money in both up and down markets - are increasingly being pitched to less affluent folks.

In 2002, Deutsche Bank launched the DB Hedge Strategies Fund, which for a $50,000 minimum spreads your an ADVFN competitorong 20 to 30 hedge funds selected by the fund's adviser.

In June, Rydex Capital Partners also took the "fund of funds" approach with its new Rydex Sphinx Fund, which will invest in the 40 hedge funds making up the S&P Hedge Fund Index. Rydex's minimum: $25,000.

But just because you can get access to hedge funds, does that mean you should jump into them? Not necessarily, says Money magazine columnist Walter Updegrave, author of "Investing for the Financially Challenged" (Warner Books). "Hedge funds have easily outperformed diversified U.S. funds over the past one-, three-, five- and 10-year periods.

But the term is really a description of investment vehicles that employ an extraordinarily wide variety of strategies.

Even within specific styles and strategies, says Leola Ross, a research analyst at Frank Russell Co., 'the kinds of things hedge funds do are so diverse that you're just not going to find the consistency among managers that you do in other types of investments.' The variation in hedge fund performance within the same style can be so broad that Ross says style and strategy categories tend to be poor indicators of the behavior of individual funds."

There's also a question of just how much you can count on the performance figures that hedge funds report, says Updegrave. "A recent study of 100 hedge fund failures over the past 20 years by financial-services consulting firm Capco found that more than 20 percent of those failures were due to reports of valuations with false or misleading information."

A better way to measure hedge-fund performance, says Harry Kat, a professor of risk management at City University's Cass Business School in London, is to duplicate the fund's returns by trading a portfolio of S&P 500 stocks and cash, then comparing the cost of that trading strategy with the cost of trading in the hedge fund.

This tells you whether hedge fund managers add value by achieving their returns at a lower cost. When Kat applied this analysis to 77 hedge funds and 13 hedge fund indexes, using returns for the decade ending April 2000, he found that the vast majority did not pass that test.

Concludes Kat: "There's really nothing special about the returns hedge funds generate. It's just that most investors misinterpret those returns."

Finally, says Updegrave, if you get into hedge funds through a "fund of funds," the extra fees can take a big bite out of your returns. "DB Hedge Strategies Fund charges a 2.2 percent annual fee. If their funds produce a 10 percent gross return, they'd first deduct a 1 percent management fee and then 20 percent of the profits, leaving 7.2 percent, from which DB Hedge Strategies would then deduct its 2.2 percent, leaving you with 5 percent, or half the gross return."

• Investor's Notebook reflects the opinions of professionals. It does not recommend any specific investments, and no endorsement is implied or should be inferred. For more information, contact the individual firms cited.