Abstract

A recent “critical examination” of hedge funds noted the growing trend for directors of university endowments to invest in hedge funds, which invest in equities and fixed income markets through specialized strategies […]

Introduction

A recent “critical examination” of hedge funds¹ noted the growing trend for directors of university endowments to invest in hedge funds, which invest in equities and fixed income markets through specialized strategies such as short selling, use of leverage, options, futures, arbitrage, or very frequent trading. These investments, usually made through lightly regulated limited partnerships, involve relatively short term speculation, in contrast to the illiquid, commitment of five years or more, made by venture capital or private equity funds to a relatively few nascent or established companies. After discussing a variety of risks present in certain hedge fund investments, and the sophistication required to evaluate these risks, the recent article reached a tentative conclusion that “hedge funds may be unsuitable” for pensions, trusts, and foundation and university endowments smaller than those of Harvard and Yale.

Just the opposite is true. That is, fiduciaries may have a responsibility to consider hedge fund investment, and that responsibility will become a legal obligation should the growing trend to hedge fund investing become as widespread as the practice of investing in stocks themselves, and hedge fund returns continue to greatly outpace those of stocks. I do not argue that hedge fund investing has yet become a legal obligation, although I have elsewhere explored the circumstances in which this could become the case.²

Sophisticated fiduciaries are increasing their allocations to hedge funds. University endowments of $1 billion or more have increased their allocation to hedge funds from 5.6% in 2000 to 17.8% in 2002.³Over the last three years, these very actively managed investments, which are likely to remain a small and changing portion of the investment world, have greatly out performed the over $ 1 trillion which is passively indexed to the S&P 500.

Summary

Hedge fund investing does indeed entail significant risks, and fiduciaries considering hedge fund investments must understand and evaluate those risks in relation to potential returns, and correlations with other elements of the portfolio. The same can be said of investing in stocks, or even passive investing in stock indexes. Fortunately, fiduciaries need not be personally expert in the investments they make, but may delegate to experts, appropriately selected, instructed, and monitored. If the analytical process leads to the conclusion that investing in particular hedge fund strategies can enhance the risk and reward characteristics of a particular portfolio, then such investments are proper. The excellent performance of hedge funds relative to stocks over the last three years, suggests that hedge funds offer just such an opportunity. While risks abound, as they do in stock investing, there are ways to mitigate them. One alternative, which permits diversification among a number of hedge fund strategies without a large investment in any of them, involves investment in a fund which itself invests in other hedge funds selected and monitored by the manager; this is called a “fund of funds.” There are even “hedge fund indexes” which are becoming available for investment, offered by Standard& Poor’s, Morgan Stanley, and others.

The Process of Hedge Fund Investing

For those unfamiliar with hedge funds, an outline of the process of hedge fund investing may be helpful. Selecting and monitoring hedge fund investments is a demanding task, requiring knowledge and vigilance. Many fiduciaries enlist the help of hedge fund consultants in making a portfolio allocation to hedge funds, and many decide on an investment in a fund of hedge funds to achieve diversification among strategies and managers, and to obtain the expert services of the”fund of funds” manager in selection and monitoring.

An investor considering hedge funds is generally looking for an investment that offers a good risk- adjusted return even when the stock market or bond market is in decline. Such a strategy is likely to produce returns uncorrelated with those of traditional stocks and bonds in the investor’s portfolio, thereby diversifying the portfolio and achieving better risk- adjusted returns for the portfolio as a whole. To achieve this, the investor must find a manager pursuing a nontraditional strategy. Both the manager and the strategy must be carefully evaluated, and expert help may be needed in the evaluation.

A good starting point in the search might be a visit on the internet to a hedge fund database to review the past performance of various strategies. Figures on hedge fund performance overall, and specific performance figures on a dozen different groups of strategies can be found at www.hedgeindex.com. The site provides a description of each strategy, monthly performance figures, and a comparison of the performance of the strategy with selected benchmarks. The figures on this site are based on selected hedge funds, and are “capitalization weighted” according to the amount of capital in each fund. Anyone can sign in to this website, simply by providing a name and getting a password.

One example of a hedge fund strategy is the “equity market neutral” category, whose subindex returned 7.42% net to investors in 2002. A manager applying this strategy to a portfolio of $50 million might invest $25 million in U.S. stocks, and sell short $25 million of different U.S. stocks. The objective is to buy stocks which will increase in value and sell those which will lose value, so that whether the market goes up or down, the investor will profit as the gains on one group of stocks outweigh the losses on the other. Leverage might be used, increasing returns, and volatility. That is, a manager with $50 million to invest, might employ leverage, in effect borrowing money so as to buy $50 million of stocks, and sell $50 million short.

The “long/short equity” category is similar, except that the manager has no commitment to weight the short positions equal to the long positions. Depending on the opportunities the manager finds, and themanager’sview of the market, the manager may have far more invested in long positions than in short positions. This is typical of most “long/short equity” managers, a category into which many managers fall, and it helps explain why the index for this category lost 1.6% in 2002. Of course, in earlier years when the market had big gains, the “long/short equity” managers had big gains too (particularly those who used leverage); much larger gain than the “equity market neutral” managers. In fact, the criticism is sometimes made that some of these “hedge fund” managers hardly hedge at all. The same criticism is sometimes made of those managers in the “emerging markets” category, who do not hedge their long exposure, and are often invested in highly illiquid securities in thin markets, to boot. Managers in the “dedicated short bias”category avoid thesecriticisms; as the name implies their short positions are larger than any long positions they hold. Notsurprisingly, this was among the most profitable strategies in 2002, with index returns over 18%; in prior years when the market registered big gains, some managers in this category incurred losses so large they were driven out of business.

Other managers fall into the “event driven” category, which is subdivided into three subindex categories. “Distressed securities,” managers generally invest in the debt instruments of companies in or near bankruptcy, and sometimes hedged by short positions in the stock of those companies, or in market indexes. “Risk arbitrage” managers take hedged positions in the stock of companies which have announced mergers. “Event driven multi-strategy” managers do not restrict themselves to one type of opportunity or another, but look for any situation where they believe that an anticipated event will trigger the realization of profit in a position.

The category most often appearing in dramatic newspaper stories is that of “global macro.” George Soros falls into this category, seeking to discern international developments in currencies, stocks, or bonds which will lead to profits. Large, leveraged bets are often made by managers in this category, and central bankers of particular countries complain bitterly when the bets are against them. Soros is blamed for triggering a major devaluation of the British pound some years ago; his response is that the devaluation was inevitable and that he merely perceived its inevitability before many others. After a record of 30 years of conspicuous success (punctuated by a few large losses from which he recovered), Soros announced that he was adopting more conservative trading methods. However, press stories report that he recently lost $180 million by investing in a hedge fund making highly leveraged long and short investments in the Japanese stock market. Some losses are inevitable when risks are taken; the fortune he amassed from years of trading is still estimated in the $10 billion range, and he devotes much of it to philanthropy.

There are many other categories of hedge fund strategies, and many variations in strategy within each category. Classification of particular funds is sometimes artificial, since a fund may pursue activities within a number of categories, or change its strategy from time to time. Therefore, it is necessary to carefully evaluate the methods of each particular, unique fund, and the qualifications and inclinations of its manager.

Detailed information on particular funds can be found at www.hedgeco.net, which is currently available free of charge to accredited investors. In order to obtain a password, the investor must fill out an internet form supplying information which establishes the accredited status of the investor. There are several other internet data bases, most charging fees of thousands of dollars per year to access information on their sites. All of the data bases overlap, but each has funds not listed on the others. Each manager decides on which data bases to list his fund, and supplies all information concerning performance and strategies, which is not confirmed by the data base manager. Hedge fund consultants often maintain data bases as well; generally, they do not allow their clients unrestricted access to their data bases, which include their own notes on interviews with fund managers. Instead, these consultants seek to identify appropriate investments for the particular client engaging their services, using their data base as a resource for that purpose.

Once the investor has focused on a particular fund, there are many questions to be asked; an extensive list of some of these questions can be found on the hedge- fund.net website. An interview with the manager is necessary to get the answers, preferably in person as well as telephonic, and preferably at the manager’s office so the work environment can be seen. Documents will be supplied by the manager, and the investor can check references and otherwise investigate the manager and the strategy.

Investors who are not accredited might seek out registered hedge fund products which are offered as mutual funds. There are relatively few such offerings at present, though more are being created, somewhat to the consternation of the SEC, which understandably wants to assure that unsophisticated investors are not misled as to the risks, and receive adequate disclosure. To this end, the SEC is considering heightened risk disclosure and suitability requirements for registered hedge fund offerings.

Most hedge funds are offered to U.S. investors as limited partnership interests. The general partner of the partnership is an investment adviser, registered with the CFTC if futures trading is involved, but often not registered with the SEC, which is considering requiring such registration. In addition to the limited partnership managed by the adviser, the adviser often operates an offshore hedge fund for persons who are not residents of the United States, and for tax-free U.S. investors such as pension funds, which can avoid unrelated business taxable income through an investment in an offshore fund established as a corporation in an island jurisdiction such as Bermuda, Cayman, or BVI. Further, the investment adviser may trade managed accounts for large investors; often a minimum of $5 million, $10 million, or more may be required to open such an account. Usually these offshore and onshore vehicles are traded in the same manner. Sometimes the adviser manages more than one strategy, each with its own set of onshore and offshore investment vehicles.

Because hedge fund partnerships are private placements limited to accredited investors, and the number of investors permitted in a partnership is therefore limited, the minimum investment in such a partnership may be $1 million or more. Restrictions on withdrawing funds from the partnership may also apply; some funds allow monthly withdrawal; others quarterly; others require a commitment of a year or more. Most warn the investor that in case of market reverses, withdrawals may be unavailable for lengthy periods, and the investor could lose all the money invested.

Given such high minimum investment levels, and the risks involved, a small portfolio may find it difficult to diversify its allocation to hedge funds, even if the proper level of understanding of each fund and its manager can be achieved. One way to overcome these hurdles is investment in a “fund of funds.”

The Legal Framework

Established principles of fiduciary law permit fiduciaries to invest in hedge funds. These principles are codified for pension trusts in ERISA, for other trusts in the Uniform Prudent Investor Act (“PIA”), and for charitable and university endowments in the Uniform Management of Institutional Funds Act (“UMIFA”) which is currently being rewritten to conform to the PIA, but which even at present gives fiduciaries at least as much investment latitude.

Fiduciaries do well to invest in hedge fund strategies, if they enhance the risk and return characteristics of the portfolio as a whole. The Prudent Investor Act provides: “A trustee may invest in any kind of property or type of investment… . “⁴ The comment explainsthat “no particular kind of property or type of investment is inherently imprudent,” noting that the “Act impliedly disavows the emphasis in older law on avoiding ‘speculative’ or ‘risky’ investments… . It is the trustee’s task to invest at a risk level that is suitable to the purposes of the trust.”⁵

The comment notes that stocks were at one time considered too risky for investment, but are now widely accepted. In 1934, a court condemned stock investing as no better than gambling: “The stock market isnot a playground for trustees. The ethics of trusteeship is not to be found in the code of the speculator…. It is no less a breach of trust to speculate with securities of an estate, than to gamble with its money, though the motive be to advance its interests.”⁶ Yet by 1986 times had changed to the point that a court held a trustee liable for failing to invest in stocks, holding the trustee liable in damages for the difference between the actual return of the trust from its investments in tax free bonds, and the amount which would have been earned if the trustee “had prudently diversified between tax-exempt and equity securities” by investing 40 percent of the trust’s assets in stocks, which would have appreciated 20 to 22 percent during the administration of the trust by the bank, as measured by broad stock indexes.⁷

What is “conservative” at one time—such as investing a portfolio exclusively in bonds—becomes a breach of trust in another. What is “speculative” at one time—such as investing in stocks—becomes required conduct in another. Times change, and requirements for the prudent investor change with them.

The test for any particular investment today is whether making the investment would improve the risk and return characteristics of the portfolio. Each decision is evaluated “not in isolation but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.”⁸

No fiduciary is expected to know everything about the full range of investment alternatives available today. A fiduciary may delegate to experts the task of analyzing and selecting investments, so long as the expert is carefully selected, instructed, and monitored by the fiduciary. This is true of fiduciaries of university and foundation boards,⁹ pension funds¹⁰, and private trusts, as discussed at greater length in the Prudent Investor Act Comment.¹¹ Adherence to the principles of the Prudent Investor Act is intended to protect fiduciaries from liability whether or not the investment proves successful, since even well considered investments sometimes fail; the test is one of prudent consideration at the time, rather than in hindsight.

A fiduciary, then, may invest in a hedge fund strategy, or any other strategy, if diligent investigation leads to the conclusion that the risk and return characteristics of the portfolio as a whole will be enhanced by the investment. In making this investigation, and selecting the investment, a fiduciary is entitled to rely on an expert, carefully selected, properly instructed, and regularly monitored by the fiduciary. Does hedge fund investing meet this test?

Recent Return Figures for Hedge Fund Investing

Hedge funds as a group have vastly outperformed the stock indices during the three years ended December 31,2002. For example, any investor would have been far better off in the CFSB/Tremont hedge fund index¹²than in the S&P 500, dividends included. The hedge fund investor would have a return of 13%, while the stock index investor would have lost 36% of the invested capital. That is, $1,000,000 invested on January 1, 2000 would have been reduced to $623,917 for the stock index investor, while the same amount invested in the hedge fund index would have grown to $1,128,127.

Of course, investors are able to invest in the S&P 500 through such vehicles as stock index mutual funds offered by Vanguard and others, whose returns are very close to those of the S&P 500. Recently, the creators of the S&P 500 index have created an index of hedge funds, which is becoming available for investment like the S&P 500. Otherwise, investors can try to construct a diversified portfolio of hedge fund strategies by investing in particular funds, either directly, or through “fund of funds” which offer such a diversified portfolio. The proprietors of the hedge fund index referenced above do not offer an index of fund of funds, but another database does.¹³The actual performance of the funds comprising this index, which are generally diversified portfolios of hedge fund managers, differs somewhat from the index, but are of the same order of magnitude, and tell the same general story by comparison to the stock indexes; an investor of $1,000,000 in these fund of funds would have seen the investment grow to $1,082,797 during the three years, compared to $1,128,127 for the hedge fund index, or a loss to $623,917 for the S&P 500.

Returns over a three-year period

	S&P	Hedge Index	Fund of Funds
2000	-9.10%	4.85%	1.11%
2001	-11.89%	4.42%	2.80%
2002	-22.10%	3.04%	4.07%
end value	$623,917	$1,128,127	$1,082,797
gain (loss)	$(376,083)	$ 128.127	$ 82.797

There is an enormous variety of hedge fund investment strategies. For example, some invest only in stocks, some only in bonds, some use only futures contracts, some only options; some use particular combinations. Some are highly leveraged, some not at all. Some invest in liquid assets, others in highly liquid assets. Some trade furiously, turning over their portfolios several times a month; others trade much less, turning over their portfolios once a year. Some invest only in Europe, or only in the US, or in emerging countries, some in different combinations. Some use only one strategy, some use several strategies, some change strategies from time to time.

Given this great variety, valid estimates of risk and return can only be made in the context of a particular proposed investment. Any blanket conclusion is questionable, favorable or unfavorable, as to whether hedge fund investing is generally good or bad. Good decisions must be made on a case by case basis, for each investment and each portfolio, as to whether or not the investment is likely to improve the risk and return characteristics of the fiduciary’s portfolio.

Funds in the hedge fund data bases are sorted into particular strategies, usually by the funds themselves, as they supply the data. This sorting is subject to the problem that some funds invest in more than one strategy, and/or change strategies from time to time, and even funds staying within a particular strategy can vary widely in methodology, leverage employed, and other important factors.

Hedge fund investing strategies offer a very actively managed way of investing in the traditional asset classes of stocks, bonds, and commodities. This is their common denominator. Hedge funds strategies themselves do not comprise a separate class of assets, any more than passive indexing (buying all the stocks in the S&P 500, for example) comprises a separate class of assets. Passive indexing is a cheap, easy way of investing in the underlying assets. Hedge funds invest in the same underlying assets, but with very active trading, typically with high costs, with special skill or perception of a special opportunity needed to achieve outstanding results, and with a substantial likelihood that the special skill or special opportunity will not persist for very many years.

For this reason, institutional investors often do not report a separate allocation to hedge funds, but instead subsume their investments in hedge fund strategies within traditional asset allocation categories. Equity- oriented hedge fund strategies are included within the asset allocation to stocks; fixed-income-oriented hedge fund strategies are included within the asset allocation to bonds. Many of these investments in hedge fund strategies are made not by purchasing a limited partnership interest in a hedge fund partnership, but rather by opening an account in the name of the institutional investor, managed in the same investment strategy as a hedge fund partnership, by the same entity which serves as the general partner of the hedge fund partnership.

Investors look at the performance of hedge fund indexes, just as they look at the performance of stock indexes. At its best, a hedge fund index represents the aggregate performance of those who are in the business of very actively managing traditional assets in a way which promises exceptional risk and reward characteristics. These indexes often are subject to survivor bias, since it has been estimated that as much as 20% of funds in a data base at the beginning of a year may have disappeared from it at the end of the year,¹⁴either because their success has helped them grow to a size where they have closed to new investors, and therefore no longer wish to provide their data to the data base as a way of attracting new investors, or perhaps more commonly, because their lack of success has driven them out of business. In this respect, hedge fund indexes are not entirely unlike such widely used stock indexes as the S&P 500, whose membership changes somewhat several times in the course of a year, as those compiling the index decide to replace declining companies in the index with growing companies.

Long Term Hedge Fund and Stock Index Returns

Comparison of hedge fund returns with stock returns over the long run is not yet possible because good long term data for hedge fund returns does not exist. Only in the last 10 years or so have significant amounts of money been committed to hedge funds, and much of that increase has occurred within the last three years. The continual creation of new hedgefunds, and disappearance of old ones, together with the great variety and changing nature of investment methodologies, and the secrecy and selectivity of the funds which themselves supply the data, makes statistical work in this field extremely challenging.

For what it’s worth, figures from the hedge fund index referenced above show that $1 million hypothetically invested in the index at its inception on January 1, 1994 would have grown to $2,285,496 by December 31, 2002 as compared to $2,219,570 total actual return from the S&P 500. The first year for the hedge fund index, 1994, was its worst, with a loss of -4%, while the S&P 500 had three losing years in a row (2000 through 2002) aggregating a loss of – 36%. This amounts to a slightly higher return from the hedge fund index over the period,with much less risk than the S&P 500.

While good long term hedge fund statistics are practically unavailable, there are excellent, accurate long term statistics for the S&P 500.They show that stocks are a highly volatile investment,despite the popular perception, fueled by securities industry marketing materials,that an investor for the long run can count on stock market returns of about 10%. Over the last century, stocks did indeed far outpace bonds as an investment; stocks provided a total return of about 10% per year, and even returned close to 7% after adjustment for inflation.

However, for particular generations of human beings with a limited life span, and even more limited span of years to invest for retirement, stock investing has been bitterly disappointing, as many can now attest after the last three years. Nor is this the first time in the last century that a generation of stock investors has been disappointed.

Real stock market returns, that is, returns adjusted for inflation, measured over every 15 year period from 1900 to 2000, have varied from -2.0% to 13.6%. Those lucky investors who bought stocks in 1985 and took their money out of the stock market at the beginning of 2000 enjoyed the highest real return of the century, which was 13.6%. Those unlucky investors who bought stocks in 1905, or 1964-1967 and took their money out of the market 15 years later, ended up with less than they started with in real dollar terms. Those who invested in stocks fifteen years ago are watching their own real rate of return fast approaching zero. And of course those who invested in early 2000 have lost 36%¹⁵of their money. Fig. 1: Real Stocks Returns 1900-2003

Source: Gary Burtless, The Brookings Institution, Washington, DC.

Recent research at the London Business School now provides us with definitive figures from 1900 to the present on investment returns in the 16 countries with the largest public capital markets, Figures derived from this work show that the years from 1980 to 2000 were the best of the century for investors in stocks, bonds, or bills, and are presented in detail in another paper by this author.¹⁶The numbers presented in these tables are the work of the Dr. Michael Staunton, one of the authors of that study.¹⁷

Actually, stock investors can be forced to waitmuch longer than 15 years, the period on which the graph above was based, without any real return at all. The following chart shows the maximum number of consecutive years during the century, in which the cumulative return on stocks did not exceed inflation. That is, an investment made at the beginning of the period would be worth no more at the end (though an investor trading in and out during the period might have made money on temporary upswings). The international average of the countries in the London Business School study, was 36 years with no return on investment, over one-third of the century. Bonds and bills were even worse; on average the number was 77, over three-quarters of the century. Stocks were the best, but no secure safe haven.

Number of Consecutive Years With 0 or Negative Real Return

Country	Equities	Bonds	Bills
Canada	14	51	51
Switzerland	15	21	68
Australia	16	87	90
US	19	56	68
S Africa	21	65	88
Denmark	22	46	27
UK	22	83	59
Ireland	27	85	57
Netherlands	28	82	82
Sweden	29	58	53
Japan	49	101	101
France	53	101	101
Germany	54	101	101
Spain	57	85	91
Italy	73	101	101
Belgium	76	101	101

These are long periods in the life of a human being, or most institutions. The investor who can really afford to take a “long term” perspective in excess of 36 years is very rare indeed. Investors who think they are assured a decent return on investment through long term, passive investing in stocks are operating under a dangerous delusion. I very much regret to report that no haven safe from economic vicissitudes is available through any investment whatsoever. Like Diogenes searching in vain for an honest man, I am still searching in vain for a truly risk-free investment. The academic favorite, Treasury bills, is subject to the risk of inflation, which at some times and places has proved disastrous.¹⁸Stocks have almost always beaten inflation, at least since inflation became pandemic after 1945, but as seen above they have not always assured a decent return after inflation.

Investors in the United States fared a bit better than the international averages. The longest period they had to wait with no real return on stocks was 19 years (rather than 36); the longest period with no real return on bonds was 56 years (rather than 77.) For the average investor, or even the average institutional board, this is a very long time indeed with no real return on a portfolio. These figures, developed in the most comprehensive study to date of a century of investment returns, report a very unpleasant fact of investment life, generally forgotten for 20 years— investors in stocks must be prepared for the possibility of a veiy long wait with no real return on their capital. We are three years into such a wait now; the wait could last for decades.

Faced with this grim reality, it is no wonder that individuals and institutions are increasingly looking to trading methods which hold out the possibility of a better mix of risk and return than that available simply by buying and holding a diversified index of debt and equities. Time will tell whether particular hedge fund investments can be found which will achieve that goal, and whether the goal might even be achieved by the investable indexes of hedge funds now being offered by such respected firms as Standard & Poor’s, creator of the dominant S&P 500 index of stocks, in which so much institutional money is invested.

Ways of Reducing Hedge Fund Risks

Given the recent record of hedge funds, vastly outperforming the stock indexes, and the risks of stock investing over the long term, many prudent investors have asked whether particular hedge fund investments could enhance the expected returns and reduce the risks of a portfolio. Like other investments, hedge fund strategies involve risk, which investors have attempted to reduce in various ways, including the following:

1. Diversification; fund of funds and hedge fund indexes.Most fiduciaries would invest only a small percentage of a portfolio in any particular hedge fund, so that the risk of loss in that fund is mitigated by other investments in the portfolio, expected to have a low correlation with returns of the hedge fund. Investors wishing to allocate a substantial portion of a portfolioto hedge fund strategies must therefore select and monitor a number of hedge funds. This task can demand considerable expertise and effort, often beyond the resources of the fiduciary. Delegation of the task to an outside consultant is possible, or the diversification objective can be achieved by investment in a “fund of funds” which selects and monitors investments in a diversified portfolio of other hedge funds. Increasingly, large and reputable financial sendees firms, including the largest commercial banks, offer such products.

The advantages of the fund of funds are clear. With several hundred million dollars under management, the manager of the fund of funds can afford the specialized staffing needed to analyze, select, and monitor the particular hedge funds in which the money is invested. The investor in the fund of funds can, with even a small investment, participate in the returns of a large and diversified portfolio of hedge funds, selected and monitored by a large, institutional fiduciary. There is a fee for the service—fund managers charge .5% to 1.5% or more as a management fee, and perhaps an incentive fee as well, in addition to the management and incentive fees charged by the underlying fund managers. However, with such large sums to invest, the fund of funds can sometimes negotiate reduced fees from the underlying fund managers. A fiduciary must be sure to analyze and compare the fees charged, as well as identifying any conflicts of interest. A disadvantage of large size is that newer, smaller, funds are often excluded from the mix, because the sums which could be prudently invested in these funds are so small that they would have no real impact on the overall portfolio. Yet some suggest that these are the funds in which the best returns can be had, before their assets have increased to capacity levels and their fees have increased commensurate with returns. The performance of a fund of funds is almost never as stellar as that of the best hedge funds.

Diversified portfolios of hedge funds are also becoming available through “hedge fund indexes” which do not attempt to identify the best hedge funds, but instead to offer a diversified sample, like the S&P 500 and other stock indexes. As mentioned, Standard & Poor’s itself is offering such an index, as are Morgan Stanley and other traditional suppliers of stock indexes, domestic and international.

2. Managed Accounts. The term “hedge fund” implies investment with others in a common investment vehicle, usually by purchasing an interest in a private partnership, offshore mutual fund, or even a U.S. mutual fund managed in a hedge fund style. Few US mutual funds offer hedge fund strategies, despite changes in the law which have made this possible. A hedge fund strategy in a mutual fund format offers the greatest regulatory protection, and also offers liquidity daily if the fund is an open-end rather than closed-end fund. The typical hedge fund for U.S. investors is conducted as a private partnership; the typical hedge fund for investors resident outside the United States¹⁹(or for U.S. tax exempt investors, such as pension funds seeking to avoid unrelated business income tax) is a mutual fund incorporated in an island jurisdiction, such as Bermuda or Cayman, and perhaps listed in Dublin. The U.S. partnership or offshore fund offers less regulatory protection than a mutual fund, relying principally on the integrity of the investment manager,²⁰and affords the investor little information about how the funds are actually invested, beyond whatever the manager may choose to say. However, this is the most common investment vehicle for hedge funds, for several reasons. Managers do not wish to incur the large costs for starting and registering a mutual fund. Regulatory restrictions on mutual funds have been relaxed to the extent that mutual funds may now engage in short selling and use leverage, futures, and options, but the remaining restrictions would prevent the use of many hedge fund strategies, and the daily liquidity requirements of an open ended mutual fund would not be possible for many hedge funds, which invest in relatively illiquid securities which may take weeks or months to liquidate properly, particularly in event of a financial crisis. Mutual funds permit incentive fees to be charged by managers, but these fees are reviewed by the SEC in approving the prospectus, so that managers may be unable to charge a sufficient incentive fee to permit running a fund the small size of which is limited by the investment strategy employed. While hedge funds are not subjected to mutual fund requirements, they are not beyond the reach of regulators; the SEC and New York’s attorney general have quickly stepped in to investigate or close hedge funds accused of fraudulent conduct, at least where the manager is in the United States, as most are.

Instead of investing in one of these common funds, an investor with sufficient sums to invest may approach the investment manager and ask that an account be opened in the investor’s name, to be managed under a power of attorney by the same managerwho runs the hedge fund, and in the same style. In such an arrangement, the investments remain in the investor’s name, greatly reducing any risk of looting, and the investor can remain fully informed as to every transaction and position in the account – the ultimate in “transparency.” Drawbacks include the refusal of some fund managers to operate managed accounts at all, or to require a minimum investment of S5 million or $20 million or more, to open a managed account.²¹ Another drawback arises when the manager’s own money is invested in the hedge fund, and the managed account may not receive quite the same level of attention as the flagship hedge fund, whose performance may as a result exceed that of the managed account. In some cases, diversification of the underlying investments requires that the managed account be very large to achieve results comparable to those of the fund. Also, highly leveraged investments can result in losses exceeding the amount invested; an investor in a limited partnership interest is protected from losses exceeding the amount invested, but the owner of a managed account is not so protected.

3. Other Custody and Transparency Arrangements. Short of opening a managed account, a willing hedge fund manager can offer other ways to improve the security of custody arrangements, and permit transparency regarding the investments that the manager is making. For example, the investor can be offered unlimited access to the prime broker’s website, so that every trade can be monitored on a daily basis. Alternatively, the investor can be offered monthly access to that information, so that the positions can be reviewed at that time, and the monthly returns verified from this independent source. To assure that the books are properly kept, and that money is not improperly removed from the fund, the investor can rely on an annual audit, but the audit is not available until many months after the year has ended, and has not always proved completely reliable in the face of deliberate fraud by the investment manager. To provide complete assurance, a few managers have placed the custody of their funds in the hands of bank trusts, along the lines required of mutual funds. Others have made arrangements with independent bookkeepers or administrators to approve any withdrawals from the fund. However, should errors still occur, these parties seldom have substantial resources to make good any defalcation.

4. Risk Analysis. Beyond the diversification, custody, and transparency arrangements to be considered by eveiy fiduciary, there are other matters of basic due diligence in evaluating the investment. Risks abound, as in the stock market where the stocks in the S&P 500 have lost 36% of their value over the last three years, and those in the Nasdaq far more. These losses amount to trillions, and dwarf the losses of particular hedge funds, though every hedge fund loss of similar size receives full scrutiny in the press. The fiduciary, or some appropriate party to which this task has been properly delegated, must thoroughly understand the strategy of the manager, and be in a position to monitor performance. Risk factors include the volatility and liquidity of the underlying investments on a regular basis, and in events such as financial or liquidity crises. The leverage employed on a usual and occasional basis, and any limits on that leverage, is an important element. The background of the people involved can be checked, both as to integrity and expertise and track record in the strategy being employed. Fees and any conflicts of interest must be thoroughly understood. All this must be done before the investment is made, and monitored on a regular basis. For hedge fund investments, given the disappearance rate of hedge fund managers, monthly rather than quarterly monitoring is appropriate; some investors (or their agents) monitor daily; others receive weekly performance reports. If the fiduciary is not equipped to do this internally, external arrangements are possible through consultants, or simply by investing through a fund of funds whose personnel carry out these steps.

Considerations of Size

Hedge funds comprise only a small part of the capital markets, despite their recent growth to somewhere around $500 billion in the aggregate; in comparison there are almost $10 trillion of stocks (several trillion less than the peak); almost $6 trillion of home loan debt, and $5 trillion of corporate debt (excluding financial institutions). Despite the increasing popularity of hedge funds, the amounts invested in them are likely to remain relatively small. Opportunities for performance far above average are limited. Even the few managers who are very successful over many years, such as George Soros or Julian Robertson, eventually leave the business. Hedge fund management is by nature a turbulent and fast-changing field. And opportunities often begin to disappear soon after capital is allocated to exploiting it, driving down returns or causing the opportunity to disappear altogether.

Because of their complexity and demand forexpertise, hedge funds are practical for portfolios as small as a few million dollars, only if a fund of funds or hedge fund index is selected, or in the rare case that the fiduciary is expert enough to select and monitor a particular hedge fund strategy, with a suitable risk and reward correlation with the rest of the portfolio. Larger portfolios, with the help of expert consultants, can themselves negotiate managed accounts or other safeguards, and select and monitor a group of hedge fund strategies which can be significant to their total portfolio return. Still larger portfolios, such as Harvard’s with $17 billion, commit a large portion of the portfolio to hedge fund strategies, many managed in-house through the staff of a large, expert, and highly compensated management company. As a practical matter, hedge funds are almost irrelevant to the largest portfolios, such as that of the Calpers pension fund, with well over $100 billion to manage; the amount which can be reasonably allocated to hedge funds is unlikely to have a significant effect on total portfolio return.