The Edmond Sun

Business

August 10, 2013

Siren songs from hedge funds

EDMOND — The “Odyssey” is one of two major ancient Greek epic poems attributed to Homer. The poem mainly centers on the Greek hero Odysseus and his 10 year journey home after the fall of Troy.  Along the way he had to encounter the Sirens, who were dangerous but beautiful creatures, portrayed as “femme fatales,” who lured nearby sailors with their enchanting music and voices to shipwreck on the rocky coast of their island. Odysseus had his crew tie him to the mast so he wouldn’t be able to steer towards the Sirens and crash on the rocks.

The Securities and Exchange Commission  may have just created a new modern Siren of sorts. They are relaxing the rules on how hedge funds can advertise and market themselves. I think it’s a mistake because it means you’re about to be bombarded with advertisements from these entities. The ads will be slick. They’ll be enticing.  They will be touting returns that most people can only dream of in an area where only the rich get to play. Odysseus and the Sirens come to mind.

Okay, so maybe you don’t need to be tied down or handcuffed to your desk, but I definitely suggest you turn the page, change the channel or do anything else to stay away from these funds! They can be destructive to your wealth and the average person has no business in such investments.

In 1999 there was a hedge fund that rode the internet craze to incredible heights. The fund was up 332 percent in that one year alone and up another 53 percent in the first couple of months of 2000.  Then the wheels came off.  By the middle of April 2000, the fund was down 89 percent in just four months. Think about what would have happened if you were an investor in that fund.

For example, let’s say you put in $100,000 on Jan. 1, 1999.  By the end of the year your account showed $432,000, at which point you owed the manager his fee, 2 percent of the account value for management plus 20 percent of the profits. That equates to $75,000. Still, you have $357,000 left, which is a 257 percent gain. What’s not to love?

But by early April the fund has fallen 89 percent for the year, bringing your account down to $39,270.  But wait, it gets worse.  You see, this is a hedge fund, so it’s a partnership.  As a partner, you are distributed paper profits every year, even if you don’t take them out of your account.

Because this was a short-term trading fund, let’s assume you were allocated all the profits in your account at the end of 1999 — i.e. $257,000.  Your tax bill at the 35 percent rate would be about $90,000.  Unfortunately, your account is now only worth $39,270. So your hedge fund investment went from $100,000 to $39,270, to a negative $50,730.  Ouch!

Before I start getting hate mail, let me say there is nothing inherently wrong with hedge funds.  Some have actually performed quite well.  The problem is that few investors actually understand how they work or what risks they are taking and the new opportunities for marketing them could make the problem worse.

Hedge funds and their managers have become almost mythical creatures where only the rich and smart get to play. Don’t we all want to get in on the action with them? When they win, it’s great. But when things go wrong — well, not so much.  They are certainly not for the average investor.

Fortune magazine editor Winslow Jones created the first hedge fund in New York City in 1948 and generated huge returns over the next 20 years.  After him came the second generation of hedge fund superstars, George Soros, Julian Robertson, and Michael Steinhardt, who made their debut in the sixties. The third generation of hedge fund rock stars included Paul Tudor Jones and Louis Bacon, who launched funds in the late eighties, when there were still fewer than 200 funds and $25 million was still considered a lot of money.  The really big money showed up in the 90s when the pension funds found them.

After that, hedge funds suffered through many ordeals that followed, including the collapse of Long Term Capital in 1995, the Amaranth blow up in natural gas in 2006, the Lehman Brothers bankruptcy in 2008, and John Paulson’s 50 percent draw down in 2011. Today there are over 8,000 hedge funds, thought to manage some $2.2 trillion.  Unfortunately for many investors, they no longer have the advantage they used to have.

There are a few things you should know that will help you steer clear of danger. The first is the name itself. Hedge funds are misnamed. Most of them don’t “hedge” at all.  They instead tend to be focused bets on very narrow slices of a sector or industry. They can also be exceptionally broad, giving the investment manager the ability to buy anything on the planet.  You need to understand what is allowed.

Also, hedge funds are typically set up as partnerships where investors become limited partners.  Because these are partnership interests, there’s no marketplace where you can go to sell your investment. Usually you have to sell the interests back to the partnership itself, which may or may not want to buy it.  Cashing out can be a challenge, especially during difficult times when everybody else wants out also.

There is a reason hedge fund investments are limited to accredited investors, i.e. investors with higher levels of income and net worth.  People should be financially and legally sophisticated before locking up their money in such vehicles.

If you can’t stand a lot of risk, volatility and lack of liquidity, then steer clear!  What’s that music I hear?  Somebody get the rope, quick!  Thanks for reading.

NICK MASSEY is a financial advisor and President of Householder Group Financial Advisors in Edmond, OK.  Nick can be reached at www.nickmassey.com.  Securities offered through Securities Service Network, Inc., member FINRA/SIPC.

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