What is a hedge fund?
A hedge fund is a legal entity which invests money gathered from its partners or shareholders – usually large chunks from wealthy individuals and/or institutions. Casual observers often confuse hedge funds with mutual funds, thinking the former a more advanced version of the latter. Such could not be farther from the truth.
Mutual funds are governed by the Investment Company Act of 1940. This act includes protections for investors, such as caps on expense rates, reporting requirements and third-party verification of assets.
Back in the 1940’s some investors wanted to put their own money to work in a manner counter to the stock market. This new pool would thereby provide a ‘hedge’ to other assets, reducing overall volatility. To achieve this, behaviors not allowed by the Act of 1940 were needed. Set up outside the Act, the regulations protecting investors could also be ignored.
In the decades since, many more hedge funds have been created. Some attempt to hedge against certain markets; most were created to avoid regulations and extract exorbitant fee income through clever marketing.
Why you should avoid hedge funds
Ridiculously high fees
Free from the constraints of regulation, many hedge funds charge exorbitant fees. A typical fee structure might include a 2% fee on assets managed if returns are negative but a 20% to 35% cut of profits – even though it is your money that is completely at risk.
Bad upside / downside potential
Hedge fund fees are not just high; they are lopsided. When fund assets go down, investors get stuck with all the losses plus an additional 2% or so hit to assets for the fee. When fund assets go up, investors only receive 65% to 80% of the gain. By their very structure hedge funds render an unnaturally inferior risk-return tradeoff.
Figure 15-1 exhibits this tradeoff. The markets present a natural relationship between risk and return. Risk rises as higher returns are sought. It is a common analytical practice to plot portfolio returns against risk on a graph. Risk is usually an estimate of volatility such as standard deviation. Plotting all combinations of investments on the same chart generates a curve, often referred to as the efficient curve. Most combinations are below and to the right of the curve. The curve itself represents combinations in which returns are maximized at each level of risk.
Granting hedge fund portfolios the benefit of returns that might be on the curve – which is a huge stretch since most hedge funds have not even come close to index returns – the design and excessive level of fees results in expected returns far below market levels for every level of risk accepted.
Imprudence
Hedge funds are not bound by regulation to maintain diversification or any other facet of rational investment behavior. Managers are free to do whatever they want with your money. Many attempt to achieve outsized returns through dangerously imprudent concentrations and derivatives. As headlines have shown, Bernie Madoff, Allen Stanford and others went further and took client money for themselves.
Lack of transparency
Though some hedge funds provide regular reports, they are not required to do so. With pricing and auditing often spotty, there is no assurance the assets purported to be held are in fact held. Mutual fund results are reported daily. Hedge fund results come out quarterly, often with huge surprises.
Poor Performance
In the book “The Hedge Fund Mirage” (John Wiley & Sons, Hoboken, NJ, 2012), author Simon Lack reports 84% of all the gains earned by all hedge funds between 1998 and 2010 went to the managers of those funds; investors in hedge funds during those same years kept 16% of the gains. Basically, investors paid through their nose to entrust money with famous managers only to earn a fraction of what they would have garnered with index mutual funds.
Figure 15-2 reveals a stunning perspective. Average hedge fund returns in every category monitored by Credit Suisse underperformed index funds tracking the Standard & Poor’s 500 in 2017 as well as the past five years, ten years, and fifteen years. They may be rich, famous and connected; but as a whole modern hedge fund managers are demonstrably among the worst investors ever entrusted with other people’s money. Stay clear.
What you should do instead
If you already hold a stake in a hedge fund, you may want to act now to withdraw your money. If you are considering a new purchase, lose the thought.
If you seek a specific investment exposure of a particular hedge fund but through a superior vehicle in terms of cost, risk-reward, safety and liquidity, choose a regulated ETF or mutual fund with similar goals. If hedge funds are the centerpiece of your investment regimen, consider a new one. Click here to read more about hedge funds.
* Data sources:
The Vanguard Group, Inc., Credit Suisse Hedge Index LLC.
Hedge fund fees modeled assume 25% of returns in excess of 6%, with a 2% minimum.