The Savvy Investor's Guide to Building Wealth Through Alternative Investments

H. Kent Baker, Greg Filbeck, Andrew C. Spieler

• Editorial: Emerald Publishing Limited
• Año: 2021
• ISBN:
  9781801171373
• Categoría: Business
• Categoría: Finance

Do you want to see your wealth grow?
If so, then this easy-to-read guide that focuses on alternative investments - hedge funds, private equity, real estate, commodities, and infrastructure - is just for you.
The fourth book in The H. Kent Baker Investments Series attempts to remove some of the mystery surrounding these investments so that you can determine whether any of these are right for you. If you're willing to gain the necessary knowledge, you may be able to build long-term wealth by taking advantage of the benefits that each investment has to offer.
The Savvy Investor's Guide to Building Wealth Through Alternative Investments is written for investors familiar with traditional investments but with limited knowledge of alternative assets and strategies.

1

HEDGE FUNDS: INVESTING FOR SHORTER-TERM OPPORTUNITIES

“Many hedge fund managers have become billionaires; perhaps this – plus their reputations as the smartest guys in the room – is why they have captured the investing public’s imagination.”

Barry Ritholtz, Chief Investment Officer of Ritholtz Wealth Management LLC

“Private-equity and hedge-fund guys typically come into a situation of mediocrity, where rapid change may result in a profit.”

Austin Ligon

Much controversy surrounds hedge funds. In the aftermath of the financial crisis of 2007–2008, many politicians and commentators identified the hedge fund industrys a major cause of this financial crisis. The real reasons are much more complicated. Although hedge funds are convenient targets, they shouldn’t be the center of the controversy. Ordinary investors typically have little understanding of hedge funds and with good reason. Hedge funds are generally private, discreet, opaque, unregulated, and require large buy-ins. The purpose of this chapter is to help you determine whether hedge funds are appropriate for your investment portfolio.

A major misconception about hedge funds is that they’re relatively new. Alfred Winslow Jones launched the first hedge fund in 1949 through his company A. W. Jones & Company. Jones wrote an article for Fortune in 1948 about current investment trends. He discussed how he took $40,000 of his own money along with $60,000 from other investors and created a fund that sold certain stocks short to minimize the risk of the long-term stock positions he held. This strategy later became known as long/short investing. Short selling is borrowing someone else’s securities, selling them, and then hopefully repurchasing them at a lower price and returning the borrowed shares to the original owner. Thus, short sellers are motivated by the belief that a security’s price is likely to decline (“what goes up must come down”), enabling them to repurchase shares at a lower price to make a profit. Jones also used leverage to magnify returns. Leverage involves using borrowed funds for an investment expecting that the investment returns exceed the interest paid on the borrowed funds.

In 1952, Jones converted his fund to a limited partnership creating a compensation structure for the fund manager, a general partner (GP), which included a 20% incentive fee based on performance. A limited partnership is a legal structure, in which limited partners provide capital for investment and the GP controls. Many limited partnerships are set up so that you can only lose the amount invested. This new structure ushered in the modern hedge fund.

Hedge funds continued to gain traction into the mid-1960s, at which point another article in Fortune highlighted their superior performance relative to mutual funds resulting in further demand. Hedge fund strategies were evolving and splintering. Jones’s original vision of hedge funds “hedging” risk gave way to other riskier strategies. In the late 1960s and early 1970s, heavy losses mounted for these new strategies, and hedge fund growth remained dormant until the mid-1980s. In 1986, an Institutional Investor article highlighting the Tiger Fund, with its double-digit performance, ignited growth. Hedge fund strategies, discussed later in this chapter, continued to evolve and expand as fund managers incorporated derivatives. Derivatives are securities that derive their value from another security or reference, such as interest rates. Some use derivatives to speculate on movements in the value of an underlying security without taking ownership.

Growth continued until around the turn of the twenty-first century, with many hedge fund failures occurring. Growth reignited with the number of hedge funds growing from about 2,000 in 2002 to around 16,000 by the end of 2019. According to Preqin, the United States remains a crucial driver of the global hedge fund industry, accounting for 75% of the approximate $3.61 trillion in global assets as of November 2019. Preqin provides data and information on private capital and hedge funds, including market-wide benchmarks.

The more recent hedge fund growth is attributable to several factors such as the low correlations between hedge fund returns and traditional assets, including stocks and bonds. Low correlation among asset returns creates greater diversification and the ability to take advantage of both ownership (long positions) and short positions, and strategies that can produce high returns in a low-yield environment. Since the financial crisis of 2007–2008, growth has mainly occurred with larger funds, which investors perceive as having better risk management systems in place. Hedge funds provide savvy investors with potentially attractive shorter-term investing opportunities.

1.1. WHAT IS A HEDGE FUND, AND HOW DOES IT WORK?

A hedge fund is a fancy name for an investment partnership that pools capital from individuals or institutional investors and invests this capital in various assets using alternative and complex strategies and techniques. The initial intent of hedge funds was to allow larger investors to “hedge their bets” by diversifying into different asset classes. As private firms, hedge funds are subject to little regulation. Their managers are compensated based on assets under management (AUM) and performance-related incentive fees. They can use leverage, derivatives, and short positions, often associated with complex investment strategies. Hedge funds are only available to accredited or qualified investors, including individuals who have an annual income over $200,000 ($300,000 if married) for the past two years or net worth of more than $1 million and institutional investors such as endowments and pension funds. These rules, mandated by the Securities and Exchange Commission (SEC), assume that qualified investors understand hedge funds’ potential risks. In 2016, new rules increased the investor pool by allowing registered brokers, investment advisors, and individual investors to show relevant educational or job experience with unregistered securities to buy hedge funds.

1.2. HOW DOES A HEDGE FUND DIFFER FROM A MUTUAL FUND?

Both hedge funds and mutual funds are PIVs. A PIV is an investment fund created by pooling investments from many investors. However, several features distinguish hedge funds from mutual funds. Worldwide, as of October 2019, 9,599 mutual funds controlled more than $17.71 trillion of assets. In contrast, hedge funds had holdings of about $3.61 trillion. Both use professional money managers and diversify their holdings. Beyond sheer size, several other features differentiate these two PIVs.

• Investment strategies. Mutual funds are readily available to the public for investment and include traditional investments such as stocks, bonds, and cash. Some mutual fund strategies involve taking a short position or using leverage. In contrast, hedge funds are harder to classify. They may carry considerably more risk, employ leverage, engage in hedging strategies, or pursue arbitrage opportunities. Arbitrage is the practice of taking advantage of a price difference between two or more markets. Hedge funds also have fewer investing constraints than mutual funds and hence have greater flexibility.
• Regulation. In the United States, the Securities Act of 1933, Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940 regulate mutual funds. However, the Investment Company Act provides the most specific guidance related to structure, operations, and pricing. Before the financial crisis of 2007–2008, hedge funds avoided most of the regulatory requirements that mutual funds had to follow. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) required larger hedge funds to register with the SEC.
• Clientele. Few restrictions exist on mutual fund investors other than perhaps a minimum investment level. As previously noted, only accredited investors can invest in hedge funds. Loosening of the restrictions occurred in 2016 to include some financial professionals and those who can successfully document that their educational and training background permits them to understand hedge fund strategies’ more complex nature.
• Fee structure. Mutual fund investors are subject to management fees, possible sales charges, and other fees. Hedge fund investors pay both a management fee based on AUM and an incentive (performance) fee based on a manager exceeding a pre-determined benchmark return.
• Liquidity. Compared to mutual funds, hedge funds are less liquid because you can’t withdraw from your investment any time you want. Some hedge funds establish gates that allow limited time windows to exchange shares or impose lock-up periods that restrict investors from redeeming their funds for up to two years.
• Transparency. Mutual funds provide greater transparency to investors about their holdings and strategies. Hedge funds tend to disclose less information to their investors to guard their superior strategies. Their secrecy stems from a fear that other managers may replicate successful strategies, reducing return potential.
• Self-investment. In a hedge fund, the expectation is that the manager invests in the fund. In contrast, the manager of a mutual fund doesn’t face the same expectation.

“Hedge fund managers charge so much more than mutual fund managers; alpha is even harder to come by. They end up selling a variety of things beyond mere outperformance.”

Barry Ritholtz

1.3. WHAT ARE THE DIFFERENT APPROACHES FOR OWNING A HEDGE FUND?

“Successful hedge funds will be entrepreneurial; it is the essence of the craft.”

Paul Singer

Three approaches are available to access ownership to hedge funds.

• Direct approach. The direct approach involves investing in individual hedge funds. You can select this method if you’re an accredited investor or meet revised requirements regarding career or education and experience. The direct approach allows you to conduct your due diligence into fund selection. Due diligence involves performing an in-depth analysis of financial, legal, and operational information on a fund before investing capital. Examples of the biggest hedge funds in the United States include Bridgewater Associates, Renaissance Technologies, and AQR Capital Management.
• Fund of hedge funds approach. A fund of hedge funds (FOF) is a hedge fund that invests in a portfolio of other hedge funds. The FOF manager makes decisions about strategy and fund selection, portfolio construction and composition, and risk management and monitoring. This approach ensures better diversification, because it includes multiple funds. If you select this method, you don’t have direct control of selected funds and have two layers of fees. Each fund in a FOF is eligible for AUM and incentive fees, as is the FOF manager. An example of a FOF is the Blackstone Alternative Asset Management (BAAM) Fund.
• Indexed approach. You can also select index funds that try to mimic the underlying strategy of a given hedge fund. An example of this strategy is a replication product. Managers try to identify the key measures that drive hedge fund performance and replicate the exposures through publicly traded securities. ProShares Hedge Replication is an example of a replication product.

1.4. WHY ARE HEDGE FUNDS VITAL TO THE FINANCIAL INDUSTRY AND SOCIETY IN GENERAL?

Hedge funds comprise a relatively small fraction of the global capital markets, and individual investors have limited abilities to invest in hedge funds directly. Given this situation, what makes hedge funds so crucial to investors?

• Use of derivatives. Since many hedge fund strategies use derivatives, implicit leverage causes hedge funds to have a disproportionally larger influence in the financial markets. The leverage occurs because derivative contracts only require a relatively small investment called the margin to control a considerably larger contract value. For instance, if the margin requirement for a derivatives contract is 5%, then the contract has 1/0.05 = 20 times leveraging component.
• Indirect investment. Although restrictions limit individual investors’ ability to invest in hedge funds directly, these investors may indirectly participate in hedge funds through institutional investors such as pension funds, endowment funds, insurance companies, central banks, and FOFs. In fact, institutional investors are the primary investors in hedge funds. Therefore, ...