Investment Consult

By Lewis J. Altfest, CFP

Whether a hedge fund is right for you

• Most hedge funds require large initial investments.

• Gains are usually taxed at ordinary income rates.

You've probably heard a lot about hedge funds lately. Many people are interested in them without quite knowing what they are. Some investors view hedge funds as aggressive plays on a strengthening stock market. Others see them as protection against a slump.

In reality, market forces can have less bearing on whether hedge funds succeed or fail than they do for stocks or equity mutual funds. That's because the managers who run these privately offered investments use nontraditional strategies to curb market risk—arbitrage, derivatives, options, futures, and currency swaps, to name some. Their goal is to allow investors who are willing to invest a hefty sum—typically at least $1 million—to profit in any type of market.

Like mutual funds, hedge funds come in all shapes and sizes, and with varying degrees of volatility. Some borrow heavily (purchase "on margin"), attempting to increase return. The rest employ one or more other hedging strategies.

Among the major strengths of hedge funds are these:

• Many can diversify your portfolio and reduce its volatility by avoiding the purchase of stocks.

• They attract top talent, because managers can earn millions of dollars a year. Moreover, hedge fund managers often invest a substantial portion of their own money in the fund, aligning their interests with yours.

• Certain hedge fund strategies—short selling, for instance—may do well in a declining market. (The short seller borrows shares of a stock whose price may drop and immediately sells them, betting that he'll be able to replace the borrowed shares with new ones bought at a lower price and pocket the difference.)

• Returns of well-managed hedge funds can exceed those of stock mutual funds over long periods.

Hedge funds have some significant weaknesses, too. These include the following:

• It's often difficult to discern a good hedge fund from a bad one.

• The SEC doesn't closely supervise hedge funds, although it's in the process of determining whether more regulation is needed.

• Your initial investment is locked up for a year, typically. Afterward, you can redeem shares only about once a month, and sometimes just quarterly.

• Expenses run high and can reduce or even eliminate profits, despite the best efforts of smart managers.

• Gains are generally taxable at ordinary income rates because hedge fund managers buy and sell so frequently.

Despite such drawbacks, I believe that a carefully selected hedge fund has a place in a physician's portfolio. Unfortunately, many doctors can't meet the large initial investment that most hedge funds require. In addition to the hefty investment, SEC guidelines require investors to have a net worth of at least $1 million, either alone or with a spouse, or annual income of more than $200,000 ($300,000 if you and your spouse invest jointly) for the past two years.

Some large investment companies, including American Express, Merrill Lynch, and OppenheimerFunds, sell hedge fund products with initial investments as low as $50,000. Nevertheless, the guidelines for net worth and income still apply, and are even higher for the Oppenheimer product.

Even if you clear the financial hurdles, I'm not suggesting you go out and bet your entire future on a hedge fund. You should own stocks, bonds, mutual funds, and real estate, too, to properly diversify your portfolio. And before investing in a hedge fund you should also understand what you might be getting into. You'll find current information at the Web sites of these organizations: Hedge Fund Association (www.thehfa.org), Magnum Funds ( www.magnumfund.com), and Van Hedge Fund Advisors International ( www.vanhedge.com).

Next, find a financial adviser who understands how hedge funds work and has dealt with one or more of them—preferably a fee-only adviser who doesn't earn commissions and can therefore give an unbiased recommendation. Ask the adviser to help you find the safest way to invest. I prefer to purchase a "fund of funds" for my clients. In a fund of funds, a manager places money with multiple hedge funds. This diversified approach can sharply lessen risk.

The cheapest way to enjoy some of the benefits that hedge funds offer is to buy shares of a mutual fund that uses hedging strategies. I recommend Merger Fund (800-343-8959), a no-load that requires a $2,000 minimum. Mostly it deals in the stocks of companies involved in mergers and acquisitions. But it also dabbles in structured notes, which are basically bonds, and mortgage-backed derivatives. This activity makes Merger Fund rather unlike a typical stock mutual fund. While returns can vary widely depending on the amount of merger activity in the market, the fund's five-year average annualized return of 9.0 percent^* is more than 8 percentage points better than that of the S&P 500 over the same period.

^*Through Oct. 24.

Lewis Altfest. Investment Consult: Whether a hedge fund is right for you. Medical Economics Nov. 21, 2003;80:14.