Hedge Your Bets

What if I told you about a secret, but reputable, $500 billion investment industry that offers an alternative to conventional stock-and-bond investing? OK, so hedge funds, or private investment funds, are not quite a secret - but they are certainly little-known and poorly understood, and typically not marketed to the general public.

Hedge funds are not for everyone. But for many high-net-worth individuals, they are worthy of consideration. And so, the following is a hedge fund primer for physicians.

What's a hedge fund?

A hedge fund is a type of fund that often uses investment techniques that are considered riskier in pursuit of greater returns. The fund is legally restricted to a small pool of investors who each invest a large sum of money.

The original hedge fund was a partnership started in 1949 by A.W. Jones, who is credited as the prototypical hedge fund manager. In fact, he gave the concept its name, as he attempted to "hedge," or protect, his partnership against market swings by "selling short" overvalued securities - meaning he made money if they faltered - while at the same time buying undervalued securities. 

Later, physicians were among the most significant early investors in one of the century's most successful hedge funds - the Buffett Partnership, started by the legendary Warren Buffett, chairman of Berkshire Hathaway.

In general, only accredited investors are legally eligible to invest in hedge funds. To qualify, you (and your spouse, if you're married) must have a total net worth of $1 million or have had an annual income of at least $200,000 in each of the two most recent years ($300,000 if you're married). You can also qualify by demonstrating that you have a reasonable expectation of reaching that limit in the coming year.

These restrictions are intended to protect less-savvy and lower-income investors from the higher risks that may be associated with hedge funds. But fund managers also have the option of allowing up to 35 non-accredited investors into their funds. That's a pretty big number, since it is fairly common for the total number of investors to be fewer than 100, so maybe you can get in that way if you don't otherwise qualify.

Hedge funds are structured as either limited partnerships or limited liability companies (LLC). Since they are generally taxed as partnerships, investors should expect to receive a Schedule K-1, complete with all the appropriate information. Moreover, transparency - the ability to look into a hedge fund's portfolio to see its holdings - has not necessarily been the gold standard in structural integrity for some hedge funds.

What they cost

The vast majority of hedge funds are less than $100 million in size, but a few go into the billions, and minimum initial investments typically range from $50,000 to more than $1 million. Fund managers, though, often give themselves the flexibility to waive minimums, counting on larger investments at a future date.

Hedge funds are not as liquid as stocks or mutual funds, and often include "lock-ups," which restrict new investors from withdrawing all or part of their investment for a year or some other time period.

Fund managers usually take for themselves a portion of the fund's assets, typically about 1 percent, in fees. (Some managers don't charge this fee.)

Also, the vast majority of fund managers, whether they charge an asset-management fee or not, participate in the fund profits, often by taking a 20 percent cut. These "performance fee" arrangements, however, are limited only by the imagination of the manager. The goal of this compensation scheme is to give managers an incentive to earn higher profits for fund investors.

There may be other terms and conditions, too. For example, a "hurdle rate" provision protects investors by requiring that an individual's account must appreciate a certain percentage before it becomes subject to a performance incentive fee. Another investor protection is the "high-water mark" provision. The high-water mark is the greatest value of an investor's capital account, adjusted for contributions and withdrawals. The provision ensures that a performance incentive fee is charged only on the amount of appreciation over and above the high-water mark set at the time the performance fee was last charged.

Rarely, a fund may provide investors with a "claw back" provision. Such provisions result in a refund to the investor of all or part of a previously charged performance fee if a certain level of performance is not attained in subsequent years. But refunds in the face of poor or inadequate performance may not be legal in some states or under certain authorities.

How they profit

As with all investments, you should read hedge fund offering documents carefully to determine exactly what type of strategy the manager means to employ. Managers typically enjoy tremendous freedom. Here are some of the ways hedge fund managers try to make a profit:

Managers who use leverage are borrowing money or securities. The theory is that the investment returns on the borrowed assets will exceed the costs of the borrowing. One example is short-selling, or "shorting" a security. In that case, the manager borrows and sells the security. He's hoping the price of the security will go down, because he has to buy it back and return it to the lender. If the price falls, he makes a profit.

Managers of so-called macro hedge funds look at the world political and economic landscape and take leveraged positions in financial instruments that reflect how they believe these coming events and trends will affect the financial markets. This is perhaps the most flamboyant of the hedge fund strategies. Macro funds tend to be large, and the offering documents give the manager wide latitude to pursue nearly any legal means around the globe to make money.

Generally, equity hedge fund managers use traditional fundamental and technical analysis techniques to take long and/or short positions in common stocks. The relative mix of long and short positions can vary with the manager's view on the market's direction, and leverage is often an integral part of maximizing the returns of such a strategy. Funds that tend to favor long positions may be called "long bias funds" while those that favor short positions have been termed "short bias funds." 

Arbitrage is the purchase of one security while simultaneously selling short another to profit from tiny price discrepancies. Leverage is a prominent feature of such funds; but higher leverage can also mean higher risk.

Other strategies include investing in derivatives, futures, and emerging markets.

How to find them

By law and by tradition, the hedge fund industry is an intensely personal business. In the case of many smaller and mid-size funds, it is commonplace for investors to speak or meet directly with the portfolio manager. Indeed, in some cases the manager is the only person with whom investors interact. Accordingly, the primary mode of attracting investors is word-of-mouth. Some managers simply believe there is a very good likelihood that the first 25 accredited investors probably have another 25 accredited friends, and that solid performance will induce word-of-mouth marketing.

Still, many hedge fund managers complain privately about how difficult it is to find investors. Word-of-mouth is sometimes not enough. Advertising is not allowed, and even hedge fund Web sites may be blinded from public view. So managers and potential investors need a way to make contact.

A Certified Financial Planner(c) or Certified Medical Planner(c) can help make such contact. If you're working with one, she should have firsthand knowledge of your financial plan into which a hedge fund is supposed to fit. An adviser who operates on a fee-only basis - free of the conflicts of interest that arise when she's being paid sales commissions for getting you into certain sales vehicles - is an ideal matchmaker.

Forms you'll receive

Once you have found the right hedge fund and received preliminary approval from a hedge fund manager, you will receive the offering documents in the mail. In the offering packet, the investor will receive the following items:

The cover letter will detail how to proceed in order to invest, and may contain wiring instructions or other payment directions. Given the sums of money generally involved, wiring is nearly always the preferred method for making an investment. The letter will also specify when the next investment period commences.

An operating agreement or a limited partnership agreement, depending on the structure of the fund, [PC1] describes the legal agreement between the fund manager and the fund investors.

Also called an offering memorandum, the private placement memorandum is a document used to actually offer an interest in the fund to prospective investors. This memorandum contains summary and detail of the various disclosures, rules, and restrictions of which both the fund manager and the fund investors must be aware.

If the fund manager is also a state-registered investment adviser, she might be required to provide you with a copy of the current Part II of Form ADV - which discloses all business relationships and activities, fee structures, and other information deemed necessary by the SEC when a fund manager registers as an adviser. Many managers strive to avoid this registration, so this document is not a part of all offering document packets. Also, SEC-registered investment advisers are not required to provide individual fund investors with Part II of Form ADV. Rather, it stays on file at the fund level.

If you'd like more information about hedge investing, its risks, and rewards, check out the Hedge Fund Association's Web site, www.thehfa.org. A good rule of thumb is to pursue fundamentals over fads, seek wise counsel when required, and always remember: caveat emptor.

David E. Marcinko, MD, is a Certified Medical Planner ©, Certified Financial Planner ©, and visiting instructor in finance for the University of Phoenix, Graduate School of Business and Management.  He is also the Academic Provost for www.MedicalBusinessAdvisors.com, and educational resource center providing financial solutions to physicians and healthcare consultants.  He is the author of Risk Management and Insurance Planning for Physicians and Advisors.  he can be reached at (770) 448-0769, MarcinkoAdvisors@msn.com, or editor@physicianspractice.com.

This article originally appeared in the June 2005 issue of Physicians Practice.