Hedge funds, those once mysterious investment vehicles of the
ultra wealthy, have recently been thrust into the public
Outsize returns combined with media coverage of the wild and
crazy lifestyles of fraudulent rogue fund managers have sparked
widespread interest in this form of investment. Colorful yet true
tales of hedge fund managers faking suicides by crashing planes
and leaping from bridges add to the mythos surrounding the
While the negative aspects of hedge funds operated by criminal
types have dominated the news and captured the public's
imagination, the fraudsters are a tiny minority of the
Tremendous positive global impact has also resulted from the
proliferation of hedge funds. One example is Paul Tudor Jones'
Robin Hood Foundation. Made up of hedge fund managers and others
in the financial business, this philanthropic organization has
distributed more than $1 billion to help fight poverty in New
The most appealing thing about the group is that all
administrative costs are paid for directly from the board of
directors' own pockets. This means 100% of donations go directly
to those who need it most. There are numerous other philanthropic
organizations that would not exist if not for the wealth creation
powers of hedge funds.
Some of you may be wondering what exactly a hedge fund is. In
the simplest terms, a hedge fund is an investment partnership
launched by an investment manager. The manager generally receives
a percentage of the assets under management as a fixed management
fee and a larger percentage of the profits earned after a
benchmark has been exceeded.
The most common fee structure is the "2 and 20" split, in
which the manager collects 2% of the assets under management and
20% of the profits beyond a certain benchmark. This benchmark can
be the overall market return or the fund's performance the
previous year. With $100 million in assets considered the
starting level for a fund to be taken seriously, it's easy to see
how hedge fund managers can become very wealthy.
The great thing about hedge funds is that within the
agreement, managers are usually free to do whatever they want as
long as it's in the investor's best interest. This makes hedge
funds flexible and able to react quickly to developing conditions
and opportunities. While clauses in the agreement generally
provide the manager free reign with the capital, funds have a
mandate as to how they invest.
There are hedge funds that invest in everything from fine art
and wine to electricity and carbon credits. Some funds have rooms
full of computer engineer types (also known as quants) working on
supercomputers to find and exploit minuscule price abnormalities
in a variety of markets. Others consist of day traders using
their skills to beat the market.
However, the majority of funds are simply long-term short
equity based, which means they take long and short positions in
the stock market just like regular investors. (The word "hedge"
in the name is largely a misnomer. Hedge funds do not have to be
hedged against anything.)
Overall, hedge funds have underperformed the market so far
this year. As of last quarter, the top-performing funds have
posted gains of around 45%. On the other side of the equation,
the big losing funds have posted losses near 25%.
Investing in hedge funds is a skill just like any other
investing strategy. One needs to choose the right manager, with
the right strategy for the environment, and one who is flexible
enough to change should the original ideas not be performing.
The major caveat to hedge fund investing is that investors
need to be accredited. In simple terms, this means being wealthy
or having a substantial annual income. The regulators consider
these individuals sophisticated enough to understand the high
risks involved in hedge fund investing. While clearly having
money does not necessarily make one a "sophisticated" investor,
it's the yardstick used by regulators. In addition, $250,000 is
usually the minimum investment, and the money is normally locked
up for a year.
The good news is that with the advent of
hedge-fund-replicating exchange-traded funds (ETFs), hedge fund
strategies are no longer reserved for the wealthy. The two major
hedge fund replicating ETFs are
Global X Top Guru Holdings Index ETF (
AlphaClone Alternative Alpha ETF (
. Most interestingly, these ETFs have beaten the average hedge
fund return of around 4 % this year. Here's a closer look:
Global X Top Guru Holdings Index ETF
Regulators require hedge funds with more than $100 million in
assets to report their holdings on a quarterly basis. This ETF
combs these so-called 13F filings, excludes high-turnover funds,
and invests in the top holdings of the best hedge
Presently, GURU has just under $150 million in assets and
charges 0.75% in annual fees. Compared with the 20%-plus fees of
hedge funds, the fee advantage with this ETF is very clear.
GURU's top three holdings are
NXP Semiconductor (Nasdaq: NXPI)
Cumulus Media (Nasdaq: CMLS)
Pioneer Natural Resources (
. Year-to-date returns are above 24%.
The technical picture is strong, with shares finding strong
support on the upward sloping 50-day simple moving average since
the start of July.
AlphaClone Alternative Alpha ETF
In the world of hedge funds, "alpha" means beating market
returns. With a little more than $17 million in assets, this ETF
-- which uses a proprietary scoring model to decide its
investments -- is very small. Most interestingly and potentially
valuable, AlphaClone has a self-protection mechanism should the
market reverse. Here's how it works: Should the S&P 500 index
drop below its 200-day simple moving average, the ETF
automatically switches from 100% long in the S&P 500 to 50%
Although it hasn't matched the performance of the GURU ETF,
AlphaClone has delivered more than 18% this year, so it is living
up to its name. The top three holdings are
Twenty-First Century Fox (Nasdaq: FOXA)
Valeant Pharmaceuticals (
American International Group (
Technically, shares have followed a similar trajectory as the
Risks to Consider:
Hedge funds and market gurus can and do lose money.
Replicating their holdings is no guarantee of success. Always
position size properly and use stops when investing.
Action to Take -->
I like both GURU and ALFA as alternatives to investing directly
in hedge funds. They both offer liquidity and performance.
Although ALFA is slow to gain traction, the hedging concept will
make the ETF a superstar should the market reverse. I would enter
both of these ETFs as breakout trades. Consider buying when
ALFA's price breaks above resistance at $35.50 on the daily close
and GURU on a breakout close above $23.
© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.