Investor IQ: Hedge Funds

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Investor IQ: Hedge Funds
By ANDREW BLACKMAN
July 3, 2007

Do you know what a "side pocket" is in the hedge-fund world? Or how much of
hedge-fund returns actually go to investors? Or what Warren Buffett had to
say about these funds recently? Well, here's your chance to prove it -- or
learn it.

First, though, we should perhaps answer the most basic question: What is a
hedge fund? It's a private investment pool catering to wealthy people and
institutions.

But opportunities to invest in hedge funds are expanding, so it might pay to
know more about them even if you're not particularly wealthy. In fact, you
might already have exposure to hedge funds without knowing it: Many pension
funds have been investing in them recently in an attempt to boost returns.
If you don't have sufficient assets and income to invest directly in hedge
funds, you can now invest in a "long-short" mutual fund that mimics their
strategies. Or you could invest in a hedge-fund company like Fortress
Investment Group LLC, which completed its initial public offering in
February.

Before you splash the cash, spend a few minutes on this short
multiple-choice quiz, where mistakes won't cost you anything.


1 What was the purpose of the first hedge fund, formed by Alfred Winslow
Jones in 1949?

A. To engage in high-risk investmentstrategies

B. To maximize returns by making leveraged bets on stocks

C. To bet on the futures market

D. To guard against a stock-market slump

ANSWER: D. Mr. Jones's original hedge fund had the somewhat conservative aim
of protecting itself against a falling market, according to Roger Lowenstein
in his book "When Genius Failed: The Rise and Fall of Long-Term Capital
Management."

Mr. Jones, an Australian-born writer for Fortune magazine, decided that,
since he couldn't predict which way the overall market would turn, he would
hedge his bets, buying stocks he deemed cheap and selling short those he
thought overpriced. That way, when the overall market moved up or down, one
half of his portfolio would benefit and the other half would suffer. His
returns would depend not on the direction of the market, but on his ability
to pick stocks successfully.

Some funds still use Mr. Jones's "long-short" strategy. But the term "hedge
fund" also encompasses other strategies, such as arbitrage (taking advantage
of price anomalies), "macro" strategies like betting on the direction of
currencies or interest rates, and "event-driven" strategies such as
investing in companies facing bankruptcy or going through a merger.
High-profile failures like the collapse of Amaranth Advisors LLC last fall
tend to draw attention to the more speculative techniques being used. But,
Mr. Lowenstein writes, "Most hedge funds are rather tame; indeed, that is
their true appeal."

* * *
2 What percentage of U.S. households currently qualify to invest in most
hedge funds?

A. 1.5% B. 4.5% C. 8.5% D. 15.5%

ANSWER: C. Currently you need annual income of more than $200,000 and net
worth exceeding $1 million to invest in most hedge funds. By that
definition, 8.5% of U.S. households qualify, according to the Securities and
Exchange Commission. That's up from 1.9% in 1982, when the SEC rules were
introduced to protect small, unsophisticated investors from getting in over
their heads.

The SEC is considering adding a requirement of $2.5 million in investment
assets, excluding primary residences. Only 1.3% of households would meet
that standard. The SEC says its proposed tightening of the rules "is
designed to help ensure that investors in these types of funds are capable
of evaluating and bearing the risks of their investments."

* * *
3 What percentage of affluent investors say they understand hedge funds,
according to a recent survey?

A. 18% B. 38% C. 58% D. 78%

ANSWER: A. Chicago-based consulting firm Spectrem Group surveyed 514
"affluent" households, defined as having more than $500,000 in investable
assets, and found that just 18% said they understood hedge funds.

Asked which of five products they considered the most risky, these investors
selected hedge funds (39%), commodities (32%), precious metals (14%),
private equity (8%) and real-estate investment trusts (7%).

* * *
4 If a typical large hedge fund generated a 12% return in a year, what would
the return for investors be after the deduction of fees?

A. 11% B. 10% C. 9% D. 8%

ANSWER: D, according to Tiburon Strategic Advisors, a financial-consulting
firm in Tiburon, Calif. A typical fee arrangement for hedge funds is an
annual management fee of 2% of assets, plus an "incentive fee" of 20% of
profits.

In this example, the management fee would take the return down to 10%, and
the incentive fee would gobble up a fifth of the profits, reducing the
investor's share to 8%. And don't forget, Uncle Sam still has to take his
share.

* * *
5 In his latest letter to Berkshire Hathaway Inc. shareholders, Warren
Buffett used which of the following phrases to describe investors' attempts
to beat the market by employing high-priced hedge-fund managers?

A. "Folly"

B. "Self-destructive"

C. A "grotesque arrangement"

D. "A lopsided system"

E. All of the above

ANSWER: E. Mr. Buffett pulled no punches in attacking what he calls the
"2-and-20 crowd" -- a reference to the fees hedge funds charge.

He claimed that the high fees set up an "inexorable math" that makes
investors poorer over time, and ended with an adage: "When someone with
experience proposes a deal to someone with money, too often the fellow with
money ends up with the experience, and the fellow with experience ends up
with the money."

* * *
6 Which type of hedge fund performed best in the first five months of this
year?

A. Long-short equity funds

B. Event-driven funds

C. Global macro funds

D. Arbitrage funds

ANSWER: B. Event-driven funds, those that invest in particular events like
mergers and acquisitions, were up 10% at the end of May, according to the
Credit Suisse/Tremont Hedge Fund Index. Long-short equity funds weren't far
behind, with a gain of 9.25%, and the overall index was up 7.86%.

The only strategy not to achieve gains was "dedicated short bias," which
emphasizes selling borrowed stocks in the hope of buying them back later at
a lower price. These funds were down 3.3% for the year, and 2.2% in May
alone.

In comparison, the Standard & Poor's 500-stock index posted a total return,
including reinvested dividends, of 8.8% through May. The average U.S.
diversified stock mutual fund returned 9.8%, according to Lipper Inc.

* * *
7 What is a "side pocket"?

A. A currency derivative

B. A separate account for holding illiquid investments

C. A reserve used to offset capital gains

D. The place where the manager puts his incentive fee

ANSWER: B. Hedge funds can stash up to a quarter of their assets in "side
pockets," separate accounts used to hold investments in nonpublic companies,
real estate and other entities that aren't easily valued. Side-pocket
accounts aren't included in performance calculations. Some regulators have
expressed concern that funds might be tempted to hide losing investments in
a side pocket to boost overall performance numbers (and, therefore,
incentive fees).

* * *
8 If you don't meet the investment criteria for hedge funds, you can always
invest in "long-short" mutual funds, which adopt hedge-fund-like strategies
in an attempt to generate impressive returns in all market conditions. By
how much have these funds outperformed regular U.S. diversified stock mutual
funds over the past five years?

A. 10 percentage points

B. 5 percentage points

C. They matched them

D. They underperformed

ANSWER: D. According to Morningstar Inc., "long-short" funds gained on
average 4.5% a year for the past five years, compared with 10.1% for U.S.
diversified stock funds. They also underperformed over a 10-year period.
Meanwhile, their average expense ratio is 2.13%, compared with 1.37% for the
diversified funds.

Investors are undeterred: Assets in long-short funds top $20 billion, up
from $10.6 billion at the end of 2005.

In one of the latest signs that more hedge-fund-like choices are ahead, New
York Life Investment Management LLC's Mainstay fund unit last month
announced three "130/30" mutual funds that will be open to small investors.
The concept: Invest 130% of assets in long positions, while selling 30%
short. The short-sale proceeds are used to fund the long extension to 130%.

* * *
9 Economists Burton Malkiel and Atanu Saha studied hedge-fund returns from
1995 to 2003. The S&P 500 recorded an average annual return of 12.4% in this
period; what was the average annual return of hedge funds, according to
their study?

A. 8.8% B. 12.4%

C. 15.6% D. 18.8%

ANSWER: A. Messrs. Malkiel and Saha found two major biases in many attempts
to give overall performance figures for hedge funds. One is "backfill bias":
Hedge funds aren't required to make their returns public, and many do so
several years after launching and only when their returns are impressive.
When those impressive returns are reported, they are "backfilled" into
databases, boosting average returns. Poor results that aren't reported don't
drag the averages down. The study found that backfilled returns have been
five percentage points higher on average than regularly reported returns.

They also examined "survivorship bias": databases tend not to include data
from funds that are defunct. They estimate that this inflates overall
performance by an average of 4.4 percentage points a year. Adjusting for
these factors leaves hedge funds with an average annual return of 8.8% for
the period studied.

* * *
10 The top 10 stock holdings account for what percentage of a typical hedge
fund's overall assets?

A. 30% B. 60% C. 80% D. 100%

ANSWER: B. Hedge funds generally are more dependent on the performance of a
few key stocks than mutual funds. The typical hedge fund has 60% of its
assets invested in its 10 largest positions, compared with 32% for the
typical large-cap mutual fund, according to a recent report by Goldman Sachs
Group Inc. The stock that appears most frequently is tobacco company Altria
Group Inc., a key holding for 59 funds. Chip maker Qualcomm Inc. appears in
the top 10 holdings of 49 hedge funds, drug retailer CVS Caremark Corp., 42
funds, and Internet search giant Google Inc., 31 funds.

Write to Andrew Blackman at andrew.blackman@xxxxxxx




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