An Intro to Alternative Investments and the World of Hedge Funds Ever heard about alternative investments?

The phrase alternative investments is basically a catch-all for a broad group of investments that are typically handled by hedge funds and involve higher risk but potentially offer significantly higher rewards. I am tempted to say that hedge funds use sophisticated, well thought out strategies but you know, many of them arent as well thought out as wed want them to be. And while investment vehicles such as mutual funds are heavily regulated to prevent loss of capital and encourage broad investor participation, hedge funds are not regulated as much and have more freedom with investor capital. Hedge fund investments are, at their core, high risk bets where investors can potentially lose all of their invested capital so the SEC only lets accredited investors put their money into hedge funds people with over $1 million in net worth excluding their primary residence and at least $200,000 in annual income. History Now for some history: The first hedge fund was started back in 1949 by Alfred Winslow Joneswhere he basically wanted to build a portfolio with minimal risk so he put together a portfolio where he bought a few stocks and hedged his downside risk by shorting a few other stocks the idea was to buy stocks that would rise and make money on the upside and balance potential losses by shorting stocks that would make money on the downside. So thats where the term hedge fund came from but I dont think the term in its fundamental sense of hedging out risk applies to todays hedge funds where the focus seems to be on embracing more and more risk to maximize returns with little thought to minimizing downside risk. To be fair, there are excellent hedge fund managers who have leveraged the freedom of the hedge fund structure to generate fantastic long-term returns for their investors but overall, the industry has performed poorly compared to most benchmarks. I think a lot of people start hedge funds for the lure of easy money and riches but soon find that beating the market and generating fantastic returns is no easy feat. Forbes Article I also came across a nice article on hedge funds by Brett Nelson on Forbes.com so let me share his data with you. According to the Forbes article, there are about 10,000 active hedge funds that manage about $2.4 trillion in assets worldwide thats a huge amount of money and there are all sorts of things that hedge fund managers can do with that money to force companies and even governments to see things their way. But, on the flip side, hedge funds also face severe 1

competition for returns from rival hedge funds and we often see hedge funds battling each other out, financially, on opposite sides of a trade. Fundamentally, hedge funds aim to make money every year while mutual funds strive to match or outperform the market even so, hedge funds have trailed the market for each of the past ten years and yet , the attraction of outsize returns continues to lure billions to various funds and strategies partly because institutions, pension funds, etc., have set aside a certain % of their portfolio for hedge fund investments despite 10 years of underperformance undeterred by high management fees of about 2% or the 80/20 profit sharing. Compare that to 0.05% in fees for the Vanguard 500 Index Fund that tracks the S&P 500 thats 200 basis points in hedge fund fees versus 5 basis points for an index fund quite a difference when applied over $2.4 trillion virtually assuring riches to hedge fund managers through fees alone. Hedge funds are also notorious for quickly moving in and out of assets if things change, hundreds of billions of dollars can exit a trade within the hour and this flash exodus, as I like to call it, can significantly move markets. With hedge funds, size also matters large pension funds, college endowments, etc., like to stay with the pack, follow the herd and find comfort in size so the larger the fund and the more better known its manager, the more money it attracts and large typically means at least $5 billion in assets under management. I guess size matters partly because its easier to blame the fund for capital loss if everyone else also piled into it. Despite the size bias, portfolio managers that do well under hedge funds they work for often strike out on their own with smaller funds and since 2010, about 250 new funds have launched while about 200 have folded so there is a lot of flux. Eight Hedge Fund Strategies Now, every new hedge fund manager tries to thinks of unique ways to generate returns and there are literally thousands of strategies they deploy and invent but, broadly speaking, all of these strategies fall under eight categories which I will list in descending order with the most popular first. #1 Long/Short (25%): Alfred Winslow Jones essentially had a long/short strategy and his original strategy is still the #1 in the hedge fund world with roughly 25% of all funds using his strategy. This strategy works best when long stocks the ones that hedge fund managers hope to profit from - are not correlated to the shorts so the longs rise and the shorts fall, simultaneously. #2: Event Driven (19%): About 19% of all hedge funds focus on event driven investing strategies such as mergers, spinoffs, bankruptcies, etc., where they look for opportunities to make money based on arbitrage, undervaluation or overvaluation because events often involve uncertainty about the future and smart hedge funds pore over the financial implications of an event to scout for opportunity. #3: Multi-strategy (17%): 17% of all hedge funds combine multiple strategies - purportedly a best of breed approach that often times manifests itself as a fund of funds which is a hedge fund that invests its capital in a bunch of other best-in-class hedge funds with differing strategies, ideally with little correlation. 2

#4: Discretionary Macro (11%): About 11% of all hedge funds focus on macro-economic or macro trends such as expectations on interest rates, the movement of the dollar versus one or more specific currencies, bets on gold, silver or other precious metals or commodities, bullish or bearish bets on market direction, etc. - often with a lot of leverage with borrowed money. Hedge fund celebrity, George Soros, is the poster boy for discretionary macro strategies and is known as well for both - massive gains and massive losses - on currency bets. #5: Systematic CTA (10%): With Systematic CTA, hedge fund managers often hire Ph.D.s who build complex computer models and trade on computer-based predictions of the future based on the analysis of large volumes of past and current data but, as many people like to say about investing, past performance is no guarantee of future results and so it is with Systematic CTA where a break from tradition can wreak havoc and have model predictions wildly differ from ground reality. #6: Credit (10%): As the name suggests, hedge fund managers look at corporate or sovereign credit for arbitrage opportunities based on differences such as what a company or countrys debt is trading at versus what its actually worth based on long-term fundamentals see, corporate debt could sometimes trade for more than what its really worth (as it did with Enron for quite a while before the collapse) or trade for less than what its really worth, as was the case with many companies at the height of the 2008 crisis so credit mispricing offers money-making opportunity. About 20% of all hedge funds deploy Systematic CTA and Credit strategies, with about 10% dedicated to each. #7: Distressed (6%): Distressed investing is sort of related to credit distressed strategies typically prey on panic and follow that rule-of-thumb of buy when others are fearful swooping in and purchasing bonds, receivables and preferred stock of companies in dire financial straits now, if these funds call it wrong, they often lose a lot of money but many losses are sometimes more than made up for by a few big wins. And finally, at #8, we have Equity Market Neutral strategies which account for only 2% of all hedge fund strategies. An equity market neutral strategy consists of a portfolio that aims to be indifferent to the direction the market moves in it basically strives for a low correlation to the market. For example, a hedge fund manager may buy five biotechnology stocks that hes bullish on while shorting five other biotechs that do not appear as promising, often with a bit of leverage thrown in to goose returns and this strategy works if the sector remains volatile so longs do better than shorts but loses money if theres a secular bull market a bit like what weve had for the first half of 2013 and also loses out on secular bear markets. To wrap up, if youre an accredited investor, make sure you do your homework before joining that elite club of hedge fund investors simply because most funds have lagged the market over the past ten years and if you do find one you like, make sure you limit your investment to an amount that you can realistically afford to lose without impacting your retirement or what youd like to leave behind for you kids. Sources: http://www.forbes.com/sites/brettnelson/2013/06/30/hedge-funds-how-they-invest-their-2-4trillion-war-chest/ Steve Pomeranz is a Managing Director for United Capital Financial Advisers, LLC, "United Capital", and owner of On The Money. On The Money is not affiliated with United Capital. 3