Hedge Funds Suitable for Retail

¶ … Hedge Funds Suitable for Retail Investors?

Hedge funds are one of the more attractive investment opportunities available. They generally perform very well, meeting or exceeding investments from other areas. This is because they can generally undertake a wider range of investment opportunities and activities than other funds, which means that they can be somewhat insulated from the dangerous downswings in the market. They do this by employing diversity in their creation, but they also engage in some investment strategies such as short sales and leveraging that are excellent at protecting the assets in the fund. However, hedge funds are also limited by regulators in a way that other investment opportunities are not. Only specific types of investors, generally institutions, can invest in hedge funds. What makes them seem so appealing to the general public is that high net worth individuals are among the specific types of investors who can qualify for hedge funds, and these high-income individuals have seen profits from their hedge fund investments that make the average investor envious, leading many to wonder whether hedge funds are suitable for retail investors.

Hedge funds have traditionally been the domain of investors with large net worth (in excess of $1 million, not including their primary residence), making them out of reach for most retail investors. There has been a recent push from the financial industry and retail investors in the past couple of years to make these funds more accessible to all. This is likely due to the stagnant economy and a renewed desire for all investors to make positive gains on their investments. This trend is fraught with many risks because the hedge fund industry is loosely regulated, the average retail investor typically has a more limited knowledge of the markets and what they are actually investing in, and the very definition of a hedge fund allows it to deal in uncommon securities, sort-selling, derivatives and leverage which carry more risk than a stock or mutual fund. The very things that make the hedge fund so lucrative for the current high-income, market-savvy investors also makes them incredibly risky for the average retail investor. Therefore, the question of whether hedge funds are suitable for retail investors can be answered in two words; probably not.

Hedge Funds

Hedge funds are different from other mutual funds and equities as they seek to give a positive absolute return, as opposed to other mutual funds which seek to "beat the market." In other words, most mutual funds are hoping to provide returns that are better than the person would do through straight investment in a financial market such as the S&P 500 or Dow Jones Industrial Average (DJIA), and in some circumstances that may simply mean losses that are not as dramatic as the losses in the financial market. However, hedge funds are aimed at producing only a positive net return which is more positive than these averages.

Because hedge funds are aimed at always creating positive financial returns, they are incredibly risky for investors because consistent positive financial returns are very difficult to create. Impatient investors that are looking for those returns can literally lead to market crashes. In order to understand this phenomenon, one has to understand the psychology of investment. Hedge fund managers sell their funds based on the notion that the invested money will consistently make money. Therefore, the fund managers try to maintain an increasing or at least level amount of money in the fund. If the fund is not performing as well as anticipated, then investor sentiment will begin to fall. The more investor sentiment falls, and then more investors will withdraw funds. This can literally lead to a run on the fund, as the more investors withdraw funds, the poorer the performance appears. This may create a panic, such as the run on the banks did in the early 1930s in the United States after the stock market crash in 1929. This phenomenon can occur even though individual investor withdrawals do not have an actual impact on the value of the fund. While the underlying net asset value (NAV) of the fund is not affected by massive outflux of cash as it might be in equities such as stocks, the flexibility of the fund manager to use leverage and short selling (for fear of margin calls) may be affected by a decline in assets.

Because of the fear of withdrawal panic, hedge funds are typically structured in a way to try to prevent early withdrawals. For example, many hedge funds have both minimum investment amounts in place as well as penalties for early withdrawal, which typically are a minimum of one year, so that the hedge fund managers will never have to struggle with the flexibility issues and will have the consistent ability to engage in the type of speculative behavior that leads to the positive returns that characterize most hedge funds. These conditions are fine for the high-dollar investor with substantial money and no real need to access their funds. However, for an average retail investor who may not be able to differentiate between standard equities and a complex hedge fund because they are not fully informed or understand the investments their money is in, there is a potential for manipulation and panic. These are two words that the Securities and Exchange Commission (SEC) is most fearful of and one of the primary reasons for regulation in the first place. The manipulation is formed on the hedge fund manager side, who may use the money to eke out a higher short-term alpha, without regard to the long-term tax impact on the investor. Additionally, the fee structure, which is typically a combination of a management fee of approximately 1% and a performance fee of up to 20% of the profits (to provide incentive to the fund manager), may hide an understanding to the retail investor of the actual return from the fund. That does not mean that the fee structure is inherently negative. On the contrary, there are some positives to this fee structure, "As alternative and hedge fund strategies tend to be more expensive, fee structures can be an issue for retail investors. By introducing performance fees, investors feel as though managers are motivated to deliver the best return they can" (Harris 2011). However, that does not mean that a retail investor can confuse overall performance return with the actual profits that the investor can expect from the hedge fund.

One of the most frightening possibilities in hedge funds is the idea of a possible panic. Investors who do not fully understand the market are more likely to engage in hasty behavior without fully understanding the longer-term consequences of those actions, and they are far more likely to do so than major investors. In terms of panic, a retail investor may react more strongly to a large percentage change in the market if they do not understand exactly how the fund is invested or the market variations than can have a temporary impact on fund performance. Generally in the stock market most investors see a gain as a good thing, but in a hedge fund depending on the particular investment mix at the time, up or down may be good. Hedge funds may post temporary losses as an investment strategy, and these strategies may be far too complex for the retail investor to understand, which not only makes them more vulnerable to panic but also to manipulation. Thus a retail investor who does not completely understand the hedge fund could cause a snowball effect of withdrawals, forcing the fund manager to generate cash to cover the withdrawals by liquidating positions. This in turn would cause the NAV to decline and instill more panic to others still in the fund, magnifying the effect. Moreover, the impact of this effect would be greatest on the retail investors in the fund.

One of the other issues is that hedge funds are somewhat difficult to locate and find, because they are very complex and they require careful management. This means that some so-called hedge funds actually introduce a greater risk of loss than some traditional investments, which means that their investors are not reaping the benefits of the hedge funds. Of course, as in other areas, unsophisticated retail investors are at greater risk than sophisticated investors. "Bonds and cash are easy to find, but it is difficult to find retail investments that truly act like hedge funds. Or if there are, they have short or unimpressive track records, or trade at large premiums to book value. That is, until now" (Lott 2011).

What Lott means by that statement is that while the market has been devastating for many investors in recent times, the volatility that makes other investments more dangerous is exactly the type of scenario that drives successful hedge fund production. The current volatility in the equity markets makes this point in time a good time for hedge funds, because they can play the market on both the up and down cycles, allowing them to pull in a higher return if done well. Unfortunately, determining which fund to go with for a retail investor is difficult, as there are many unscrupulous fund managers who might seek to take advantage of the fact that they are playing with other people's money and making (at least) the management fee. This can lead even scrupulous hedge fund managers to take unnecessary risks.

The danger of hedge funds being mismanaged truly cannot be overstated. For example, Bernie Madoff ran a large exclusive fund and while it was a Ponzi scheme, which while illegal and with "fantasy returns," that sophisticated investors most certainly should have realized were not realistic, Madoff continued to be able to bring in investors. However, Madoff's investors were all relatively financially sophisticated people with huge assets. While his scheme caused them financial damage, the damage was manageable and it was confined to a group of people with assets that greatly outstripped those of the average American. In other words, none of Madoff's investors went hungry as a result of his scheme. However, it is not difficult to imagine what might happen if there was a hedge fund which purports similar returns to a larger retail investor audience which sought to make its money not in a small number of individual clients with large investments, but with huge number of small investors from the general public. If any one of these went under, it could literally threaten the retirement and assets of middle-income individuals. If that occurred, then the government would be under pressure to do something to ameliorate the problem, and any investment that seems to invite the idea of a government bailout makes people nervous. Since this type of behavior has happened before (Internet bubble, housing bubble, etc.) it is likely that in this day and age of high technology another industry will come along in similar fashion. This seems likely given the fad and glamour the media is focusing on the hedge fund industry. While there is legitimacy to the use of hedge funds in an investor's portfolio, the potential abuse of hedge funds for retail investors seems more dramatic given the fact with leverage and short-selling as part of the design one could lose more than the initial investment. This specific aspect may be particularly troubling for retail investors to handle as it is not a simple concept and requires a detailed knowledge of money and mathematics.