My Yahoo!That still holds true today, but there's one big difference. Besides a 20% cut of profits, most managers also charge a 1% management fee whether the fund makes a profit or not. Jones' fund managers received nothing unless the fund was in the black. Nowadays hedge funds come in numerous forms. Generally, they are unregulated investment vehicles that can invest in whatever type of security the manager chooses.
Because hedge funds are unregulated, managers are free to sell short, use leverage, and invest in illiquid securities--activities not open to mutual-fund managers. Traditional funds have more tightly defined benchmarks and boundaries. A European stock fund must invest in large European stocks at all times. Hedge funds have a simpler goal: make money.
Hedge funds are far more exclusive than mutual funds. The regulatory agencies of most developed countries forbid hedge funds from marketing to unsophisticated investors, usually defined as those having assets worth less than $1 million. With investment minimums ranging from $50,000 to $5 million, hedge funds usually attract only the wealthiest of investors.
The small guy's only option is a fund of hedge funds. These--which now make up $75 billion of the $400 billion total hedge fund universe--are a way for less-wealthy investors to take advantage of the stellar talent that hedge funds often offer. One manager picks five or six good hedge funds representing a variety of strategies; the minimum investment is usually far lower than the $1 million or so required for a hedge fund. Deutsche Bank sells a retail version of a hedge fund of funds to small investors in Germany and the U.K.
The drawback: The fund of funds investor pays fees to the fund of fund manager and to the managers of the underlying funds. Funds of funds got their start when Burch took over Jones' New York asset-management firm in 1983. Instead of running one hedge fund managed by several different managers, Burch assigned each guy to run a different fund. He charged his investors a fee for managing the fund, plus separate fees for each of the underlying funds.
One reason for the current popularity of hedge funds and funds of funds is the failure of traditional asset managers to meet the needs of sophisticated investors. James P. Owen, a money manager, hedge fund investor and the author of The Prudent Investor's Guide to Hedge Funds (Wiley, 2000), attributes a large part of the problem to the cult of relative performance.
Pension-fund managers and most mutual-fund managers are evaluated by their employers and industry consultants on relative performance. A technology fund, say, that lost 30% in the past year is a shining star if the Nasdaq is down 60%.
Owen doesn't buy it. "You can't pay the bills with relative performance," he says. Hedge funds have brought the idea of absolute performance back into style. For Owen, it's a matter of simple math. His goal is a seemingly modest 15% return each year, with no losing years.
Not very exciting, you say? Well, in any given year, 15% isn't hard to achieve. But 15% over an investment lifetime is a tall order for a fund that can't make money in falling markets. Only hedge funds--by selling short and tapping into a wide range of strategies like arbitrage--can do the trick.
Here's why 15% is such an exciting number. At the market's long-term average of 9% annual returns, $1 million invested over 25 years would be worth a handsome $8.6 million. But if you invest that same million over 25 years and achieve a 15% annual return, your nest egg will grow to $33 million.
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