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Hedge funds may be unwise for smaller investors

Posted: Friday, November 08, 2002

NEW YORK (AP) -- Once reserved for the wealthy, hedge funds now offer the promise of hearty returns to smaller investors in the worst of financial times. But the loosely regulated ventures come with substantial risks and aren't for everyone.

These funds use leveraging and complex trading methods -- including short selling and investing in commodities, foreign currencies or troubled companies' debt -- to achieve gains no matter what the market does.

Hedge funds have outperformed mutual funds during the three-year bear market, creating demand for these investments among less wealthy investors. As a result, the number of hedge funds jumped from less than 1,000 a decade ago to 5,500 this year, with assets totaling $560 billion, according to the New York-based Hennessee Group, which advises hedge fund investors.

Hedge funds traditionally required investments of at least $1 million. But investors who pay as little as $5,000 can now join what are called funds of hedge funds, which own slices of different hedge funds.

That worries some analysts. Hedge funds often act on as much speculation as they do on market fundamentals, which could pose a problem if lesser-qualified managers are hired to meet a rush of investor demand.

The alternative investments also tend to underperform in bull markets and their risky methods can cause sudden losses -- often without investors' knowledge, since the funds aren't required to disclose holdings.

''Hedge funds have turned into a mass-marketed, mass-produced commodity and there just can't be enough talented managers to run the funds out there,'' said Roy Weitz, publisher of FundAlarm.com, which advisers investors on mutual funds.

Last month, for example, Beacon Hill Asset Management suddenly closed two of its hedge funds. And in 1998, Long-Term Capital Management collapsed on bets on bond interest rates, prompting the Federal Reserve, fearing a threat to the banking system, to engineer a $3.6 billion rescue.

''The high-profile blowups are going to happen more,'' Weitz said. ''There are going to be people who are incompetent, dishonest and fraudulent, and they are going to start creeping in in greater numbers.''

So far this year, the average hedge fund lost 5.5 percent, according to Hennessee, less than the 19.4 percent drop reported by Morningstar Inc. for the average equity fund. In 2001, hedge funds gained 4 percent, compared with the average equity fund's 12 percent loss. But hedge funds' performance also lagged the S&P 500 index during the bull market years of 1995-98.

And they bring risks. Unlike mutual funds, hedge funds and many funds of hedge funds are not regulated by the Securities and Exchange Commission. They are not required to disclose holdings, returns or even their existence beyond what is spelled out in a contract with investors.

Indeed, Beacon Hill surprised investors by announcing it would suddenly close two of its largest hedge funds after suffering losses of more than 50 percent, or $400 million, in recent months. As late as August, investors were told the funds were up 10 percent.

And the SEC launched a probe of the hedge fund industry in May, noting ''the information we have about them is sketchy.'' One area of focus is how hedge fund managers, whose pay is tied to fund performance, value holdings, since investors must often rely solely on their word.

''We have always advised investors to investigate before they invest, and to keep themselves as well-informed as possible about any investment they are considering,'' said John Heine, SEC spokesman. He declined to comment on the probe.

There are other drawbacks to hedge funds. Fees are stiff, with managers taking 1 percent or 2 percent of net assets, plus 20 percent of the annual return; some have front-end sales charges as well.

And given the stock market's recent upswing, hedge funds may not make sense, particularly for short-term investors.

''If you look at expenses, it might be more economical to get into a mutual fund,'' said Charles Gradante, Hennessee's president and CEO. Noting that many hedge funds have hidden fees, ''you've got to be in a bear market for hedge funds to really pay for themselves.''

Many analysts advise those unfamiliar with hedge funds to refrain from investing unless they get good referrals from friends or join funds of hedge funds from companies such as American Express or UBS PaineWebber, which typically register with the SEC.

Even then, analysts say investors should consider waiting until the SEC completes its probe, which could take a year, since many believe it could result in significant changes to the industry.

''In past times, hedge funds have been restricted to very wealthy individuals because it was thought they had the resources to withstand the individual risks,'' added Dan McNeela, Morningstar analyst. ''That might serve as a warning to other investors.''

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On the Net:

Hennessee Group: www.hedgefnd.com

Hedge Fund Association: www.thehfa.org

Morningstar: www.morningstar.com



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