Preliminary estimates from Hedgefund.net show that in November, hedge funds topped the $2 trillion mark in assets for the first time this year. The steady rise in money coming in shows a return of investors trying to chase higher returns using alternative investing strategies. However, the total assets held in hedge funds are still $900 billion below the peak in 2008. (Learn more about hedge funds in Hedge Funds Hunt For Upside, Regardless Of The Market.)
Hedge Fund Basics
From Long Term Capital Management's blow up in the late 1990s, one that required a Federal Reserve organized bailout to save the financial system, to the more recent debacle of Bernie Madoff's hedge fund Ponzi scheme, hedge funds often make more news for blowing up rather than their performance. (For more, check out Hedge Funds: Higher Returns Or Just High Fees?)
Another reason most people don't hear about hedge funds is that they can't invest in them. The Securities Act of 1933 requires companies that offer or sell securities to register with the SEC or find an exception. Hedge funds use sections of Regulation D to sell to what's known as "accredited investors." So, to invest in a hedge fund, a person needs to have $1 million net worth or have earned $200,000 in income in each of the last two years. This makes them an accredited investor, and makes hedge funds out of the reach of average investors.
Hedge funds employ a variety of strategies in trying to generate returns for their clients. Often complicated in execution, and sometimes fraught with risk, let's see how hedge funds did over the first 11 months of 2009 as reported by Hedgefund.net.
- Sector funds focus on a specific area or market. The regional/country-specific fund indexes in Russia and Brazil did well with 60.82% and 52.85% gains respectively. The lowest performing country sector fund index was Middle East/North Africa region with a 23% gain. The sector funds focused on energy and healthcare didn't do as well, but still had gains of 36.25% and 26.03% respectively.
- Distressed debt funds specialize in buying low-priced corporate fixed income securities from firms that are in, or about to be in bankruptcy, with the potential of gaining from reorganization of the firm or liquidation of the equity if there is enough assets to pay off the debt. Through November the index has gained 26.54%.
- Fixed income arbitrage funds use various techniques, such as interest rate swaps, to exploit small inefficiencies in various markets. Because this is typically high leverage, some have called this picking up nickels in front of a steam roller. Nevertheless, this strategy shows a gain of 17.81% YTD.
- It wasn't long ago that mortgage-backed securities were the peril of the entire economic system, but mortgage-focused hedge funds have done well this year so far and are up 50.62% YTD.
- The long/short equity funds did OK with a 19.84% gain. This strategy both buys some stocks and sells (shorts) other stocks at the same time. The idea is that big market swings should be muted and just the stock picking of the manager should show through.
- The market neutral equity strategy tries to make money in any market condition. This is supposed to be a low risk strategy which may account for the low return of only 4.48% YTD.
- A more aggressive strategy is a short bias strategy that tries to find stocks that are going to go down in value and sell them short hoping to buy them back at a lower price in the future. This year so far it's taking a hit this year as the market up quite a bit, but it's down 16.65% YTD.
- Commodity and foreign exchange (FX) related strategies haven't done nearly as well as the other strategies this year. Commodity focused funds use managed futures to trade commodities and they have only gained 4.87% so far this year. Foreign exchange focused funds are only up 1.93% YTD and financial futures focused funds are only up 3.11% YTD.
The Bottom Line
So were the accredited investors fortunate to be able to get into these investments? Some have done pretty well, others weren't stellar at all. The more typical investor could have used index funds to gain about 20% from the Dow and S&P, even better from the NASDAQ. Far better than last year's calamity, but still nowhere close to back to even for most people, even accredited investors. (For more, check out Can You Invest Like A Hedge Fund?)