March 01, 2014

Should You Invest in Hedge Funds? An Interview with Harold S. Zlot, chairman of Access Fund Management Co.

The Investment Strategies Committee

We’ve all heard of hedge funds, but few of us know what they are and even fewer have considered investing in them as part of our investment planning. To help understand the role of hedge fund investment and dispel some of the myths that cause people to avoid them, Bruce Mann, chair of the Investment Strategies Committee, interviewed Harold S. Zlot, chairman of Access Fund Management Co., an investment advisory firm focused on advising clients on investments in hedge funds.

Mann: Most of us have heard of hedge funds but don’t know what they are. Can you explain what a hedge fund is and how it differs from a normal mutual fund?

Zlot: Though both hedge funds and mutual funds invest client assets into a professionally managed portfolio of securities, hedge funds can be managed more aggressively to produce higher, risk-adjusted returns. For example, hedge funds can trade derivatives, short-sell stocks, and take on leverage. More aggressive management allows hedge funds to produce positive returns even when the overall market is declining, while mutual funds are not allowed to take the same risks. In terms of eligibility, hedge funds are only available to accredited investors the U.S. Securities and Exchange Commission deems sophisticated based on net worth or income requirements, while mutual funds are publicly available to all investors.

Mann: For an individual to be an “accredited investor” eligible to invest in hedge funds, the investor and his or her spouse must either have a net worth excluding the primary residence of $1 million or an annual income of $200,000 (or $300,000 with the spouse) during each of the last two years and a reasonable expectation that they’ll also have it in the year the investment is made.

Zlot: That’s right for individuals; of course, there are other tests for institutions and for trusts.

Mann: Okay, but why should our readers be interested? Aren’t hedge funds secretive, risky, loosely regulated playgrounds for the super-rich?

Zlot: Today, hedge funds are far from secretive and are actually heavily regulated by the U.S. government. However, because hedge funds have historically been unable to advertise publicly, many investors are not aware of the universe of funds. Hedge funds ought not only be for the “super-rich,” either; even though many hedge funds have high minimum investment amounts, there are multimanager funds available that provide a diversified portfolio of hedge funds wrapped up into one set of terms. That means that an accredited investor can gain access to a broad portfolio of hedge funds that is professionally managed while only needing to meet one minimum investment amount.

Mann: If hedge funds are a conservative investment, should they be expected to underperform the market?

Zlot: Though a given hedge fund may be conservative or not, it doesn’t always correlate to the overall market. Everyone is going to have investments in the stock market, but the question is, should you put all of your net worth in the market? If the answer is no, the nonequity investments should prove to be protective in an environment in which the stock market has a big downturn. At times, hedge funds will underperform the market, but they should prove to be more protective of capital in troubled markets. What’s more, if I have $100 and lose 50 percent, I need to make 100 percent to get back to $100. Once you lose money, it can be very difficult to make it back up.

Mann: If markets are efficient, I don’t understand how a hedge fund can outperform the typical mutual fund.

Zlot: Many stock markets are efficient most of the time but inefficient some of the time. Some emerging markets or fixed-income markets are frequently inefficient. Furthermore, the problem with this conjecture is that hedge funds are not publicly available to every investor, while mutual funds are. The barrier to entry protects returns from an overabundance of demand, while, on the contrary, the accessibility of mutual fund products should effectively lower returns and volatility as they grow very large from demand. These mutual funds tend to be highly correlated to the stock market and more susceptible to drawdown, while hedge funds are managed to avoid large drawdowns and preserve capital.

Mann: But since hedge funds can’t advertise, how can I find a good one and avoid the risk of investing in another Madoff-type Ponzi scheme?

Zlot: Though hedge funds can’t advertise, there is an abundance of information online that ranges from manager interviews to assorted rankings. From there, an accredited investor can look up most hedge funds and make contact with them directly to receive relevant information to make an investment. The drawback is that rankings and articles only open the window to a small percentage of the overall hedge fund universe. According to PerTrac, there are over 10,000 active hedge funds. Moreover, once an investor finds a few hedge funds of interest, the proper due diligence is taxing and, if not done properly, can leave an investor susceptible to fraud. A fund of hedge funds, or multimanager fund, is a great way to invest in a portfolio of hedge funds that have been researched and vetted properly.

Mann: But if I invest in a fund of hedge funds, aren’t I paying a second layer of fees for something I can do myself?

Zlot: The amount of due diligence necessary to find high-quality hedge funds and structure a portfolio, not to mention avoid potential scams, is likely to be more than any single investor can handle on his or her own. The second layer of fees goes towards immense due diligence and background checks, excellent manager selection, and diversification. A high-quality fund of hedge funds should reduce overall risk through portfolio management on 15–30 individual hedge funds. Given most of these funds have $1 million minimums or more, it would be difficult for all but the largest investors to gain access to a portfolio of hedge funds.

Mann: How much do I have to invest if I decide to put money into a fund of hedge funds, and what portion of my investment portfolio do you think I should allocate to hedge fund investments?

Zlot: It depends on the risk tolerance and liquidity profile of the individual investor. Hedge funds typically have a one-year lock-up and quarterly liquidity. An investor needs to ask him- or herself, in order to sleep well at night, how much of my net worth do I need access to on a day’s notice? Major investment banks will typically recommend that between 10 and 30 percent of capital be in alternative investments (including hedge funds, private equity, and real estate). We’ve seen many ultra-high-net-worth families have allocations north of 50 percent in alternatives.

Mann: So, to summarize, you think that anyone with total assets of $5 million or more should consider investing in hedge funds, not as a speculative device but to reduce risk and smooth returns in his or her investment portfolio. Harold, thank you very much for your insights.

The Investment Strategies Committee

Bruce A. Mann, chair of the Committee and primary writer of Committee columns, is a senior partner at Morrison and Foerster in San Francisco.