Capital Fools | Investing news, guides, and analysis

Know your Hedge Fund Types

Hedge funds have thrived on their ability to focus on a particular investment niche. Exploiting mispriced assets has allowed hedge funds to generate significant sources of alpha, or excess return, for their clients. But this out-performance does not come free; management fees average 2% plus 20% of the profits (known as the 2 and 20 model). Let's take a look at the the most common strategies employed today.

Convertible Arbitrage: This exotic-sounding name involves buying undervalued convertible bonds (or preferred stock, or warrants) and shorting the underlying stock to create a hedge. The strategy pays off when the value of the convertible bond increases, earning interest on the short-sale proceeds, and/or a further decline in the stock price. Note that this only works when there is a mispricing in the underlying convertible bond and the stock.

Distressed Securities (AKA Vulture Funds): Can be equity or debt securities. A "distressed" company is one that is in or very near bankruptcy. Investing in them requires rigorous analysis on their financial condition to determine if the company can turn itself around. There is potential for a high return. But of course the risks are commensurate with the potential reward.

Emerging Markets: Long-only funds that invest in emerging markets. Shorting and use of derivatives is not available since emerging market countries lack the market depth that developed markets have.

Equity Market Neutral: These funds exploit price discrepancies with combinations of long and short positions. For example an equity market neutral strategy combines a long undervalued position and short overvalued position, which eliminates most of the market risk (but not all).

Fixed Income Arbitrage: Take long and short positions in fixed-income instruments based on expectations of changes in the yield curve and/or credit spreads.

Fund of Funds (FOF): A hedge fund that invests in other hedge funds. They can typically invest in 10-30 different hedge funds with differing investment styles. FOF give investors diversification in the hedge fund universe but must pay an added layer of fees - one to the underlying hedge funds and one to the FOF.

Global Macro: A multi-faceted strategy that attempts to profit from major market trends in both the financial and non-financial markets. Global macro funds use an array of investment vehicles, such as: traditional stocks and bonds, futures, options, commodities, and currency.

Hedged Equity Strategies (AKA Equity Long-Short): The largest of all hedge fund investment strategies, these funds are similar to equity market neutral funds that take can take long or short positions. However these funds don't attempt to combine offsetting long and short positions to eliminate market risk. There can be net-long or net-short positions in different sectors of the market.

Merger Arbitrage: Also called "deal arbitrage" funds, they attempt to realize value from corporate actions like mergers and acquisitions, spin-offs, takeovers, etc. Typically they buy the stock of the target company and short the stock of the acquiring company.

Lehman Fails

Financial market duress, coupled with prior government interventions, has facilitated the failing of a major investment bank. Lehman Brothers failed not just because of its leverage, but because the information the US Government sent to the market by bailing out Fannie and Freddie. The Government had to save these GSE's, but a direct side-effect out this bailout was the imminent failure of a highly-leveraged corporation. Lehman Brother is merely a minor casualty in the ongoing credit crunch. The one positive is that an investment bank was allowed to fail, the market was allowed to function properly and its assets will be disposed of in an orderly fashion. Yes, equity holders and unsecured bondholders are wiped out, but that's how the system works. Capitalism requires financial destruction to rein in excessive risk-taking behavior.

Let's celebrate the fact that Lehman was allowed to fail, as it's the last thing US taxpayers should be on the hook for.

Goodbye Lehman.

Alternative Assets: News

Infrastructure funds are rushing to dispose of assets to solidify their balance sheets according to the Financial Times. The credit crunch has made these assets less appealing to investors as the security of their yield is being called into question. What started with Babcock & Brown, a premier infrastructure fund manager, liquidating assets has turned into a rush for the exit.

Why is this happening? The global credit crunch is punching holes in the funds model of using high amounts of leverage to amplify traditionally staid returns. The funds are also facing investor scrutiny for their practice of raising debt to pay part of their yield, an unsustainable and increasingly expensive process. Increasing leverage to provide a commiserate increase in returns works fine when credit is cheap and asset prices are increasing. However, increasing leverage has a downside, and when you combine highly-leveraged balance sheets, stable or falling asset prices, and expensive credit you have a recipe for disaster.

What does it mean for investors? Be wary of currently listed yields, as funds like MIC are under no obligation to maintain their current yield levels as the market climate turns negative.

Economic Outlook: Week of August 25th - 29th

There will be plenty of economic data coming out this week that will test the market and will give traders a better idea of the health of the U.S. economy. Here are a select few indicators set to be released this week.

Tuesday, August 26th

Indicator: Consumer Confidence
Expectation: A reading of 53.0 vs a prior reading of 51.9 in July.
Importance (1-10): 9
Rationale: Consumer spending makes up 2/3 of the U.S. gross domestic product. Gauging the sentiment of consumers indicates their willingness to spend and their outlook for the future. July's reading still shows consumers are deeply pessimistic about the future. August looks to be slightly better thanks to the drop in gas prices and other consumer goods prices easing.

Indicator: S&P Case-Shiller Home Price Index
Expectation: N/A
Importance (1-10): 7
Rationale: This index measures home prices in 20 metropolitan areas in the United States and is based on a three-month moving average with a two month lag in reporting. Tuesday's release will give an idea how home prices did in June. We here at Capital Fools have no reason to believe that the data will show an improvement in home prices. Expect further pain in the U.S. housing market.

Wednesday, August 27th

Indicator: Durable Goods Orders
Expectation: No increase vs a prior reading increase of 0.8% in June.
Importance (1-10): 7
Rationale: Durable goods orders measures the dollar volume of orders, shipments, and unfilled orders. Durable goods are goods and products that last longer than three years (dishwashers, airplanes, etc) and are an indication of future manufacturing activity. An expected increase of 0.0% for July does not bode well for the manufacturing sector of the U.S. economy.

 

Saving for College: 529 Plans

Saving enough money to pay for your child's tuition can be a difficult task. Education costs have been rising faster than the general rate of inflation. According to the College Board, in the 2007-2008 school year a public 4-year university will cost $6,185 a year (up 6.6% from last year) and a private university will cost $23,712 a year (up 6.3% from last year). Even more problematic for parents is the uncertainty of how much to save for college. Saving too much can be even worse than not saving enough. We will help you sort through this morass by examining how 529 plans can make saving for college easier.

There are several different plans available for individuals to save for college that offer tax incentives and control over how the money is invested. The preferred method to save is with the 529 plan, named after the corresponding section in the IRS tax code. Other ways of saving include: Coverdell education savings accounts, UTMAs, trusts, standard brokerage accounts, retirement accounts, and savings bonds. The 529 plan has a clear advantage over the other saving accounts due to its tax incentives, flexibility, and control.

529 benefits:

• Tax-free asset growth
• Tax free distributions for qualified education expenses
• Some states give tax breaks on contributions
• Can claim HOPE and Lifetime Learning credits for qualified expenses not paid by plan
• Donor controls the account
• Anyone can contribute and can gift up to $60,000 a year per child (a special tax election is required for this)
• Account beneficiary can be changed to another family member
• The account owner can take back all funds contributed (subject to penalties and taxes, see below)

529 drawbacks:

• Investment choices may be limited
• Fees can be high
• Some states cap size of annual contribution
• Only cash contributions, no appreciated stock
• Non qualified distributions are taxed at your current rate and may incur a 10% penalty

What to look for when examining 529 plans:

• Diversification: There should be a good selection of funds not concentrated in one specific area of the market
• Fees: Should be reasonable
• Flexibility: Ability to adjust investment mix
• Fund choices: Look for the quality fund families like Vanguard, American Funds, and Oppenheimer Funds

Morningstar's Best and Worst 529 plans for 2008

Best:

1. Illinois Bright Start College Savings Program
2. Utah Educational Savings Plan
3. Maryland College Investment Plan

Worst:

1. Ohio Putnam CollegeAdvantage
2. Mississippi Affordable College Savings Program
3. New York 529 College Savings Program

Last Words:

Choosing a 529 plan is just one part of the college planning process.  Other factors include: how much you save each year, where your child will go to college (private vs public), and your tax situation. A detailed savings strategy coupled with the selection of the correct 529 plan can help reduce the burden of higher education. The next article in our Saving for College series will give you five easy tips to improve the affordability of college.