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Hedge funds being rolled out for smaller investors

A column offering help for your wallet

By Katherine Vogtcovered hospital and personal finance issues, physician/hospital relations, and ancillary health facilities for us during 2003-06. Posted Nov. 14, 2005.

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Once a super-exclusive club for the ultra-wealthy, hedge funds are opening their doors to investors, such as physicians, who aren't in quite such rarified air.

As a result, money is flowing in. According to Chicago-based Hedge Fund Research Inc., there are about 8,000 hedge funds -- including funds that consist of other hedge funds -- with more than $1 trillion in assets. In 1990, about 600 hedge funds had $38 billion in assets. State pension funds and college endowments are among those that have enthusiastically jumped into hedge fund investment.

The "hedge" in hedge funds comes through the fund's philosophy of trying to mitigate market risk by holding long positions in investments it thinks will rise, and short positions in those it thinks will fall.

Some funds have a conservative, long-term strategy, but many sell themselves on the fund manager's prowess of beating the market -- by a lot. That can make hedge funds, despite the hedging, among the riskiest investments, or among the most spectacular investments, you can make.

"One of the reasons physicians tend to jump on these bandwagons is that they go from being a noninvestor for years to all of a sudden being an investor, and they feel they need to play catch-up. Because of that, they feel they have to hit a home run. ... Things like this tend to pique their interest more," said Mary McGrath, executive vice president of Physician Advisory Resources, a Champaign, Ill., financial services firm that caters to physicians.

McGrath said her physician clients began asking about hedge funds a lot more in the last year or two. She recommends them to some, but not all.

"If you've got a large enough portfolio and you're dealing with an investor who is sophisticated enough to understand, then I don't mind putting them in," she said. "But I don't like to go into them too heavily because of the additional fees involved and the additional volatility."

Creating a hedge fund

Historically, hedge funds were available only to those who knew someone associated with the fund who had $1 million or more to invest, said David Grenier, president of Cutler Capital Management LLC, a Worcester, Mass., investment management firm and operator of a hedge fund. "They tended to be very big, very exclusive and very private," he said.

After word leaked out that some hedge fund investors did well despite the market downturn in 2001 and 2002, interest was sparked and new funds were created to attract more types of investors. Now, some hedge funds have minimum investment requirements somewhere between $10,000 and $50,000.

William Walker, chief executive of the Grand Rapids, Mich., chartered trust bank Legacy Trust, said hedge funds can be used as a risk reduction tool for a portfolio. But he said investors need to be cautious not to get too swept up in the hedge fund craze, using them for "steak and sizzle" instead of a long-term strategy.

A hedge fund is a type of mutual fund in which a limited number of individuals pool their money, which then can be used for a wide array of investments. Derivatives, short-selling, commodities, currency -- you name it, it can be included in a hedge fund.

With this freedom comes risk. The Securities and Exchange Commission does not regulate hedge funds. The fees are enormous, compared to mutual funds -- an annual management fee of roughly 2% and an additional "performance-based fee" of 20% to 30% of any profits. You will be required to lock in your investment for one, three or five years, reducing liquidity.

Unlike a mutual fund, a hedge fund does not have to declare its investments, even to its own investors. "They're not going to want to be sharing that with the investing public because they are attempting to exploit it," said Walker.

A strategy of short-selling -- essentially, selling a stock before you've actually bought it -- is incredibly risky, because if your stock doesn't falter, your fund can incur a big loss. (A short position means you are selling an investment before you buy it. You lock in a sale price, then buy the stock for your sale when it, presumably, drops.)

The risks of hedge funds have become particularly apparent recently, with the public implosion of some large funds.

Most notably, the two founders of the $450 million Bayou Management hedge fund of Stamford, Conn., in September pleaded guilty to federal fraud charges amid evidence the fund reported gains to investors when it actually was losing money.

The most well-known case involving a hedge fund collapse was the 1998 fall of Long Term Capital Management, which received a $3.6 billion Wall Street bailout organized by federal regulators for fear of the repercussions on the world economy if it failed. The fund had borrowed 100 times its capital to invest in complex derivative contracts worth $1 trillion, then couldn't honor its side of the contracts.

Any physician who invests in a hedge fund needs to have a lot of confidence in the fund manager, experts say. Walker recommends using a neutral third party such as a fee-only financial adviser to find the right fund, rather than going directly to a manager who might make a biased pitch. Others advise using large financial institutions that have departments dedicated to screening hedge funds.

The financial pros and cons may also hinge on the tax consequences of the hedge funds. Walker said their profits are typically categorized as short-term capital gains, which means they are taxed at a higher rate than long-term investments.

Despite the risks, experts expect to see growth in the industry persist -- along with the number of pitches to investors such as physicians.

Katherine Vogt covered hospital and personal finance issues, physician/hospital relations, and ancillary health facilities for us during 2003-06.

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