Hedge funds, those once mysterious investment vehicles of the ultra wealthy, have recently been thrust into the public eye.
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 business.
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 business.
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 York City.
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 (NYSE: GURU) and AlphaClone Alternative Alpha ETF (NYSE: ALFA). 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 funds.
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), and Pioneer Natural Resources (NYSE: PXD). 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% short.
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 (NYSE: VRX) and American International Group (NYSE: AIG).
Technically, shares have followed a similar trajectory as the GURU ETF.
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.