‘Think twice be­fore mov­ing into hedge funds’

Hedge funds are sold on the ba­sis that they can pro­tect cap­i­tal dur­ing mar­ket down­turns while gen­er­at­ing above-av­er­age re­turns in nor­mal mar­ket con­di­tions. But events over the past year have proved th­ese claims to be un­true. At the re­cent se­ries of meetin

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Hedge funds are not all they are made out to be, Piet Viljoen says. Over the past year, when mar­kets tum­bled and hedge funds were sup­posed to pro­tect in­vestors from the down­side, they un­der­per­for med bal­anced unit trust funds by 5.1 per­cent for the year, he says.

“Gen­er­ally, sim­ple bal­anced unit trust funds are a very good al­ter na­tive to hedge fund in­vest­ments, as they earn you com­pa­ra­ble re­turns, but at a lower level of risk than most hedge funds,” he says.

Viljoen says that al­though hedge funds may at times of­fer higher re­turns, they have a greater risk than bal­anced funds of un­der-per­form­ing and even col­laps­ing.

On the ac­com­pa­ny­ing graph, which shows prob­a­bil­i­ties of re­turns, the blue line shows the monthly av­er­age re­tur ns you could ex­pect from a bal­anced port­fo­lio. The red line shows the monthly av­er­age re­turns you could ex­pect if you added a hedge fund to your port­fo­lio. Your monthly av­er­age re­turns are higher with the hedge fund and you get lower re­turns less of­ten.

How­ever, Viljoen says that if you look at the left-hand side of the graph, the red line is slightly higher than the blue line.

“At this point, hedge funds are more likely to lose large amounts of money. Al­though this is ex­tremely rare, ex­tremely neg­a­tive events seem to oc­cur more of­ten with hedge funds than with plain vanilla funds. As War­ren Buf­fett says, a long string of im­pres­sive num­bers mul­ti­plied by zero equals zero,” he says.

The price you pay for earn­ing higher re­turns with a hedge fund is the pos­si­bil­ity of los­ing all your money if the fund col­lapses, he says.

Hedge funds are con­sid­ered riskier in­vest­ments largely be­cause hedge fund man­agers use gear­ing. This means they bor­row money to buy more shares, un­like man­agers of or­di­nary funds, who are not al­lowed to use gear­ing.

Viljoen says that when it comes to in­vest­ing, peo­ple of­ten do the ex­act op­po­site of what they would do in everyday sit­u­a­tions.

“For ex­am­ple, in in­vest­ments, when prices go up, every­one wants to buy, and when prices fall, every­one wants to sell.

“But if the price of bread dou­bled, you wouldn’t ex­actly see peo­ple queu­ing up to buy bread. In the case of a sta­ple item such as bread, peo­ple re­act more ra­tio­nally.

“When the mar­ket goes up, hedge fund man­agers be­come su­per­heroes, be­cause they of­fer high re­turns, and every­one wants to in­vest in hedge funds. But when there is a bear mar­ket, hedge funds close and in­vestors lose in­ter­est in them,” Viljoen says. In the past year or two, there have been a num­ber of spec­tac­u­lar hedge fund fail­ures. For ex­am­ple, com­mod­ity trader Amaranth lost 60 per­cent of its as­sets un­der man­age­ment in one month, and, in 2007, Bear Stearns credit funds col­lapsed. Lo­cally, the Ever­crest Ag­gres­sive Hedge Fund, worth about R120 mil­lion, col­lapsed, and in­vestors lost about 60 per­cent of their cap­i­tal.

Viljoen says when­ever there is huge ex­cite­ment about a par­tic­u­lar type of in­vest­ment, crooks come out to play. A prime ex­am­ple of this is the re­cent Bernie Mad­off scan­dal in the United States.

He says that al­though there are many very poorly man­aged hedge funds, there are some good ones too.

Sta­tis­ti­cally, hedge funds add to your in­vest­ment port­fo­lio’s re­turns and di­ver­sify your risk to some ex­tent.

“Smart peo­ple with cal­cu­la­tors can show you quan­tifi­able and mea­sur­able re­turns for your port­fo­lio, but in prac­tice this is sub­ject to cer­tain risks, which are of­ten mis­rep­re­sented to you,” Viljoen says.

He says too of­ten in­vestors have no idea of what a hedge fund is or how it works, but they in­vest in it based on the “fan­tas­tic re­turns” they are promised by an en­thu­si­as­tic hedge fund man­ager.

“It’s tan­ta­mount to pay­ing a high price for a sealed black box when you have no idea what’s in­side,” Viljoen says.

LU­CRA­TIVE FOR MAN­AGERS

Viljoen says in­vestors of­ten over­look the huge ben­e­fits of hedge funds for hedge fund man­agers.

Fund man­agers of nor­mal funds, such as unit trusts, charge you about one to two per­cent of your as­sets a year in a highly reg­u­lated in­vest­ment en­vi­ron­ment. Banks gen­er­ally earn around one per­cent on their as­set base, also in a highly reg­u­lated en­vi­ron­ment.

Hedge fund man­agers, on the other hand, earn two per­cent a year plus per­for­mance fees, and are very lightly reg­u­lated, he says.

“It’s no won­der a num­ber of fund man­agers move into hedge funds. It’s not be­cause they are bet­ter man­agers. It’s be­cause they get paid more and are reg­u­lated less. Most hedge funds are lit­tle more than an al­ter­na­tive re­mu­ner­a­tive scheme,” Viljoen says.

The bot­tom line is that hedge funds are risky in­vest­ments that are largely un­reg­u­lated.

The golden rule of in­vest­ing is that you should un­der­stand what you are in­vest­ing in. If you don’t un­der­stand an in­vest­ment, you should not in­vest in it.

“Your duty as an in­vestor and a con­sumer is to do your home­work. It is your re­spon­si­bil­ity to fully check any in­vest­ment you make,” Viljoen says. “Nei­ther the gov­ern­ment nor any reg­u­la­tor can save you from un­scrupu­lous op­er­a­tors.”

He says the odds, un­for­tu­nately, are stacked against you, the in­vestor.

“There are a lot of clever peo­ple out there try­ing to part you from your money. If you do want to in­vest in a hedge fund, you should get proper fi­nan­cial ad­vice from an eth­i­cal in­de­pen­dent fi­nan­cial plan­ner who is not af­fil­i­ated to any one in­vest­ment com­pany,” he says.

Piet Viljoen of RE:CM

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