The Problems With Hedge Funds

To a lot of people, hedge funds seem like the VIP room of investing. They are the high flying stars of the investment world, and they can easily get the best managers to run their money.

They can clearly make you more money, so you should put some money there (but not too much – you want to keep your risk in check), right?

Well, no.

Hedge funds aren’t a miracle investment reserved for the wealthiest investors. They’re really just expensive, actively managed funds with a lot less regulatory oversight than a traditional mutual fund.

Hedge Funds are Insanely Expensive

First, let’s look at raw expenses. The stereotypical hedge fund fee is “2 and 20,” meaning the fund charges 2% of your invested assets and 20% of the profits you make. While both sides of this have started to come down, that’s still a huge fee. Let’s look at the average mutual fund expense ratio for different classes of funds in 2015 for some perspective:

2015 Average Expense Ratio
Actively Managed Equity Fund 0.84%
Actively Managed Bond Fund 0.60%
Index Equity Fund 0.11%
Index Bond Fund 0.10%

Data courtesy of the Investment Company Institute. Expense ratios are measured as asset-weighted averages. Data exclude mutual funds available as investment choices in variable annuities and mutual funds that invest primarily in other mutual funds.

Even if we assume hedge funds can add value for their investors (we’ll come back to this later), these expenses are a massive hurdle. And remember, it’s not just the raw expenses—you have to pay performance fees, too (which mutual funds don’t have).

Think about that for a second—not only do you have to make enough to cover the managers’ annual expense ratio, the managers also take one-fifth of any profit you make.

If they’re getting paid that much, these managers must be some of the best in the business, right? Well, that’s making a pretty huge assumption—that there is actually any skill in investment management.

Hedge Funds are Glorified Actively Managed Funds

Hedge funds are just actively managed funds. Sure, they have fancy titles and the managers’ names are often followed by “Ph.D.” But underneath all of that is them saying that a particular set of stocks will “beat the market” (however they define that). Active management does not work. It’s just noise. If it were possible to consistently beat the market, the data would say so. But the data is pretty clear – there is no skill in active management.

Hedge funds are doing largely the same things as traditional actively managed mutual funds, just with some window dressing and better marketing. There’s no reason to believe that the results you would get from a hedge fund are any different than you would get with a generic mutual fund anyone can buy.

Hedge Funds Don’t Hedge

Even aside from their stock-picking prowess, hedge funds claim to provide significant diversification benefits. They are hedge funds, after all. They say they can get you spectacular returns while being uncorrelated with the market. It’s the best of both worlds—high returns and volatility reduction.

The thing is, this isn’t the case. In the classic paper “Do Hedge Funds Hedge?” three hedge fund managers looked into whether hedge funds really had any diversification benefits. They concluded that “the return and diversification benefits vanish for the broad hedge fund universe and many sub-categories.”

In short: no, hedge funds do not hedge. They look like the market.

Hedge Funds are Hard to Own

Not only are hedge funds really expensive actively managed funds that don’t really provide much diversification benefit, you have to jump through all sorts of hoops to own them. To invest in many such funds you need to be an “accredited investor.”

See, hedge funds are very lightly regulated, and you don’t get all of the information you would in a typical mutual fund. The government wants to protect everyday investors from unscrupulous managers, so you need to be accredited, (which basically means you have to have significant resources) to invest in hedge funds.

But even if can invest, you are often subject to lock-up periods and liquidity windows. If the fund you invest in has these “features,” you can only get your money out when the managers say it’s okay. Plus, like I said, you don’t necessarily get the same amount of information about your investment as you would in a typical fund. Less transparency is rarely a good thing

But Do They Work?

I’ve laid out a whole bunch of reasons to be skeptical of hedge funds. A reasonable question to ask is “What do the returns look like?” If they provide the returns, then they might be worth a place in your portfolio. But the returns are pretty ugly.

Like most things in finance, Warren Buffet provides a really good example. He made a $1 million bet with Protégé Partners that they could not pick a portfolio of hedge funds that would beat Vanguard’s S&P 500 index fund over a ten-year period.

As of the end of 2015 they were eight years into that bet, and it’s not looking so good for the hedge fund folks. At the end of 2015, VFINX (the Vanguard fund) was up 65.67% overall. The hedge fund portfolio was only up 21.87%.

Hedge funds are not some magical investment solution that will fix your investment portfolio. As you can see, they are expensive, investor-unfriendly, actively managed portfolios that don’t actually hedge anything. It may not be quite as exciting, but sticking with your plain vanilla portfolio built around your risk tolerance is much more likely to help you meet your financial objectives.

For more on how to get the most out of your portfolio, take a look at our ebook, Pursuing a Better Investment Experience.


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