Hedge Funds for the Masses?

Simeon Hyman

Those who caricature hedge fund managers portray them as rich, secretive market gurus who occupy cult status among admirers and envious followers. For many, the term "hedge fund" itself has an almost showbiz allure and the big names that occupy this space are certainly larger-than-life figures. Consider George Soros, who broke the Bank of England; John Paulson, the contrarian who foresaw the collapse of the U.S. housing bubble; and David Einhorn, the bad boy who made a fortune off the demise of Lehman Brothers.

Historically, hedge funds have been the exclusive domain of the wealthy. Often set up as private investment partnerships -- as opposed to mutual funds or ETFs -- many require investors to be wealthy enough to be a "qualified purchaser" under Securities and Exchange Commission guidelines. On top of the SEC guidelines, they also often have high minimum investments and high fees that keep smaller investors at bay. Many hedge funds use the 2-and-20 model - taking an annual fee of 2 percent to manage money, while keeping 20 percent of any profits.

But it's a common misconception is that all hedge funds are inherently risky, aggressive and speculative. While some do live up to this reputation, many do not. The industry has opened up, in a way, to smaller investors recently with the proliferation of mutual funds and exchange-traded funds that follow hedge-fund-like investment strategies. These funds aim to bring some of the benefits of hedge funds to retail investors, often with lower fees.

BloombergBlack counts more than 50 such funds that follow hedge-fund-like strategies. With so many to choose from, it can be tough to decide which ones are best. Their names don't offer much help. Instead of easy-to-understand titles such as "U.S. Large Cap Stock Fund," these funds are often given names that include terms like "absolute return" and "tactical opportunities." Nevertheless, the right fund can offer an advantage seen in many hedge funds: meaningful portfolio diversification.

When selecting one, it's important to understand both the fund's strategy, and the role it could play in a broader portfolio. Hedge funds strategies vary widely -- some follow long/short stock strategies, for instance -- and don't focus on diversification. In practice some can behave a lot like regular stock funds that follow long-only strategies. So adding a fund following a long/short stock strategy to your portfolio is similar to adding any actively managed stock mutual fund seeking to outperform a benchmark. Other hedge funds trade in and out of a broad range of investments like commodities, currencies, stocks and bonds. Those funds can potentially deliver uncorrelated returns (meaning they could do well when the broader market is trading lower and might not do as well when the market is trading higher). However, investors should be aware that such strategies can introduce liquidity or leverage risks.

These are still early days for hedge-fund-like mutual funds and ETFs. Some "investment snobs" see them as the poor man's hedge fund, destined to underperform the real thing. Others are exploring the advantages of these over traditional hedge funds that include daily liquidity, transparency and lower fees.

Simeon Hyman is Chief Investment Officer of BloombergBlack, a new offering available by invitation to affluent investors looking for a smart, easy way to take control of their personal wealth. For more information, visit BloombergBlack.

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