It’s fun to jump on the bandwagon and slam hedge funds. Blow-ups, writedowns, meltdowns and financial catastrophe are the words of the day with regard to hedge funds.
I thought we would separate the wheat from the chaff this month and discover the real reasons why hedge funds can be good for a portfolio, and what to look for that could get you into trouble.
Fiction: All hedge funds are risky.
Hedge funds were originally introduced to reduce risk in a portfolio, hence the name. It may be an oversimplification, but the original idea was that if you could isolate a good manager’s ability from the gyrations of the market, you could have a portfolio that zigs when other’s zag.
This was the opposite to academic gurus who came up with the Capital Asset Pricing Model (CAPM), which suggested that non-market risk should be eliminated through diversification, and hence market risk should be the only risk that an investor should be exposed to.
If you define risk by the volatility of returns, which is generally accepted, then some hedge funds are risky and some are not.
Fact: The two things that generally make a hedge fund volatile are excessive leverage, followed by a liquidity crisis.
Whether it was Long Term Capital Management back in 1998 or other high-profile hedge fund problems, the common denominator in disaster is generally debt or leverage. This should be no surprise, as it is the same with everything in life. Fortunes have been made in real estate because of leverage, but real estate can be the fastest way to the poorhouse if your investment is overleveraged — just ask all the real estate gurus who went bankrupt in the early 1990s.
