Hedge Funds - Case Against, Part 2

Last Updated Apr 9, 2010 3:13 PM EDT

In part one, I wrote about a compelling case for using hedge funds. In this column, we will look at some of the cons and reexamine the arguments to use hedge funds presented in that column.

I'm not denying that hedge funds worked until recently for endowments like Yale and Harvard, but the average accredited investor doesn't have billions of dollars to invest. Let's look at the five arguments against hedge funds.

1. Too Expensive - A typical hedge funds works under a "2 and 20" model. This means the hedge fund manager charges the investor two percent annually based on the investment plus 20 percent of any gain. I've written against using the average mutual fund which charges about 1.3 percent, so a fund that makes a ten percent gross return would actually keep about four percent and give the investor only six percent.

2. Encourage risk - Looking at the "2 and 20" model, the best way for the hedge fund manager to make a killing and end up on the Forbes richest person list is to take risk with your money. Say I manage a billion dollar hedge fund which gives me a nice income stream of two percent annually or $20 million. But who can live on that since it will take me a few years to buy that yacht I really want. Thus I use leverage and take a very big bet with the money. If I'm right, I can turn the billion into six billion dollars and pocket a billion for myself. If I'm wrong, I'll just go back to Wall Street.

3. Risky ones attract new money - I've written against performance chasing on mutual funds but I put out the warning ten-fold when it comes to hedge funds. Most advisors select the ones that performed the best, and logic dictates that those happen to be the ones that use the most leverage and happened to win the big bets. Thus, investors are picking the ones that are most likely to blow up.

4. Inefficiencies reduced - Unlike mutual funds, many hedge funds are playing in a space that is less efficient than stocks and bonds. Unfortunately, now that hedge funds have attracted so much new capital, more money is chasing the same inefficiencies. This leaves a much more efficient market and makes it much harder for the manager to add value.

5. Lack of Liquidity - Unlike mutual funds, you can't just sell your hedge fund and get your cash in a couple of days.

6. Lack of Transparency - Bernie Madoff and others have painfully shown the downside of this con.
A reality check on hedge fund performance.
In my last column, I noted the 19.1 percent loss in 2008 followed by the 2009 gain of 18.6 percent, according to the Credit Suisse Tremont Index. But was this really market beating performance?

In actuality, these returns are nearly identical to a simple 60 / 40 equity and bond portfolio, which is why your portfolio should be near an all time high. But is this really a fair comparison?

The hedge fund index return means the investor needs to accept greater liquidity and transparency risk. In return, the investor should demand a higher return.

Second, I question the accuracy of this Credit Suisse / Tremont index in the first place. See, hedge funds don't have to report their returns and survivorship bias may be running rampant on this index. One of the funds that went out of business was managed by Tremont itself which happened to be a feeder fund into Bernie Madoff's ponzi scheme.

My advice
If I had a dime for every time I've heard that hedge funds provide above market returns with lower risk, I'd be a very rich man. Every time I hear this claim, however, I ask for any evidence that supports it. I have had no takers to date, though maybe this column will change that.

Unless you happen to have a few billion to invest (and give me a ring if you do), I'd steer clear of hedge funds as they provide too much risk with too little return.

But do hedge fund of funds eliminate the extra risk? I'll examine this in part three.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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