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When Should You Invest in Hedge Funds?

Hedge funds had a bar year; so is there a better time for investors to get in?

It’s been a bad year for hedge funds, rivaling the financial crisis year of 2009. Despite the roaring bull market, many funds have paltry gains, some have big losses. So for many investors this has been an unhappy time to invest in hedge funds.

According to a recent Bloomberg article, meager returns caused massive shutdowns in the industry. With average industry returns of only 2% this year, 461 funds closed their doors in the first half 2014. While the S & P 500 has risen more than 150% in the last 6 years, equity hedge funds have averaged little more than 40%.

So if it’s been a bad time to invest in hedge funds as this bull market has been roaring, when would be a good time?

S & P 500 5 year 12-4-14
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Remember What Hedge Funds Do

Hedge funds cater to wealthy clients, most of whom have a net worth well over $1 million. The funds usually take both long and short positions, and often make big directional bets on the markets. They seek to profit in any kind of market, bull or bear.

While many of the funds hold positions in recognizable stocks, such as going long eBay Inc. (EBAY) or Alibaba Group Holding Ltd (BABA), or short, say, JC Penney Company Inc. (JCP)) or Herbalife Ltd (HLF), funds also tend to hold more exotic positions. They might buy or short, for example, distressed securities or high-risk corporate bonds.

Hedge funds attempt to maximize profit and minimize, or “hedge,” risk. They can be highly leveraged. Many hedge funds also charge 2% management fees and take 20% of the profits.

Why Invest in Hedge Funds at All?

Not only have the returns been meager for many of the funds, for some they’ve been downright dismal. Woodbine Capital Advisors closed down this year after its assets melted away to $400 million from $3 billion in 2010. Other funds remain open but struggle. York Capital lost 6% during October, which reduced its year-to-date gain to 1%. Commodity funds that went long oil, plunged.

Managers cite the macro trends of low interest rates and low volatility as factors keeping results down. But with such poor returns across the board, why even invest in the funds at all? Indeed, that’s the kind of sentiment we’ve seen, based on the many investors who withdrew their funds.

But that doesn’t mean hedge funds are going extinct…

Past Returns and Glory Days

The all-purpose disclaimer, “past returns may not be indicative of future performance” applies to hedge fund investing with a vengeance. Yet tremendous returns by legendary managers have built the industry’s appeal.

The most legendary name among hedge fund managers is George Soros. Soros famously shorted the British Pound in the early 1990s for a  reported gain of nearly $2 billion in one week at his Quantum Fund. What’s Soros’ long-term record? How about 20% annual gains over four decades?

Another hedge fund titan, Julian Robertson, who owned Tiger Management Ltd., is said to have turned an initial $8 million into $22 billion in a little less than two decades. Superstar Stanley Druckenmiller, who worked for Soros then founded Duquesne Capital LLC on his own, produced 30% average annual returns.

These superstars, now retired from active management, had their bad bets and losses. But what investors know most about these managers is that the stars often produced outsized results for their clients.

Managers, Not Timing

Many investors follow today’s hedge fund stars, such as David Einhorn, Bill Ackman, Carl Icahn and others. Some of the funds run by these managers are stellar. Ackman’s Pershing Capital has a 42% return through November of this year, while Tepper’s Appaloosa Management produced a 42% net return in 2013.

Maybe the question should be, “with which manager are you going to trust your money?” After all, hedge funds are supposed to be all-weather investment vehicles.

Stanley Druckenmiller said in an interview with Market Folly last year that managers had to be bolder and take more risk when they had a winning hand. In a separate Bloomberg TV appearance in 2013, Druckenmiller also emphasized that managers had to have a few big positions.

Concentration, not diversification, wins the day in the hedge fund world.

The Takeaway

Investors should seek out the funds with the best managers. You should investigate the track record of the manager any fund you’re considering. It’s not a guarantee of success, but it helps. Also, investigate what the fund does. At least you should have an idea if the fund you’re going to put your fortune with invests in an obscure emerging market import company or a tech giant that’s a household name.

You should make sure you’re comfortable with high risk, as there’s plenty of it with these funds. Then and only then should you get in.

As of this writing, Greg Sushinsky did not hold a position in any of the aforementioned securities.

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