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Q: Hedge Funds
July 2011
Question: Recently, I was talking about retirement and my goals with my long-time financial advisor. He was advising me to get involved with hedge funds. I have $3 million and the minimum investment is $500,000. I don't like the idea because there are so many unknowns. You often don't know for a while where the investments are, what's happening, who's buying and selling what, and what sort of side-pocket type things are going on. I wanted to know what your thoughts are.
Ric: At Edelman Financial Services, we do not recommend hedge funds for our clients, for the reasons you cite. However, I must admit that hedge funds might make sense for certain people in certain circumstances. Hedge funds can give you access to a sector of the market or a style of investment management that you might otherwise not be able to obtain. Depending on the fund or funds you select, you might actually reduce your investment risks rather than increase them.
Because of the concerns you cited, you should not place more than 20% of your portfolio into hedge positions, and you might consider only 10%. Within that context, your advisor's recommendation is not objectionable.
There are three things you need to watch out for. First, you need to understand why your advisor is recommending this strategy and how it fits in with the rest of your portfolio. If you don't understand what that hedge fund is going to be doing with your money, then don't invest in it.
Second is liquidity. Many hedge funds have limited liquidity. They only allow you to liquidate every quarter and you typically must give 10 or 20 days' notice if you want to withdraw money. If you buy a hedge fund with that kind of limitation, make sure you can live with it.
The other thing to watch out for is the compensation structure. Many hedge funds have astonishingly high fees. One common fee schedule is "two and twenty," where you pay a 2% annual fee (based on the value of the account) plus 20% of the profits above a benchmark. For example, say your fund's benchmark is 10% and your fund rises 15%. In this example, the hedge fund would collect a 2% management fee plus 1% (that's 20% of the profit that's above the benchmark). Result: You earn 12%, and the fund gets 3%.
I've seen "three and thirty," and even "four and forty" fee schedules. These expenses are extraordinarily high, and the funds say they are justified because you will be making so much money. Will your advisor's compensation be increased as a result of your investment? If so, he may be suffering from a conflict of interest.
Having said all that, make sure your advisor can explain how you'll be better off with hedge funds in your portfolio than without them. If he can't, don't invest.
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