(MoneyWatch) The $2 trillion hedge fund industry has taken quite a battering of late. According to HedgeFundResearch.com, the average hedge fund is up only 4.5 percent year to date through October. This is less than half of the 10 percent return of the balanced traditional 60 percent stock/40 percent bond in low-cost index funds. The funds have shown the same dismal performance over last five years compared with the same indexed portfolio.
What went wrong?
Hedge funds explained
Hedge funds come in a variety of flavors, but I explain the concept to my students as follows. I take a student's book and pretend he is willing to sell it to me for $20 while the student next to him is willing to buy it for $21. As the hedge fund manager, I take advantage of this arbitrage opportunity and pocket the buck without taking any risk. In fact, the concept is even better as it's not related to how the stock market is doing. Thus the promise of hedge funds was absolute returns, meaning hedge funds would zig while the stock market zagged.
Funds promised virtually risk-free return and, for a while, that even justified the fees charged (typically known as the "2 and 20" model -- 2 percent annually plus 20 percent of the gain). In fact, fund managers could invite selected parties known as accredited investors to the table, eliminating the common investor from this party.
Why the party ended
Continuing with my example, another student sees the buck I pocketed and decides to enter my space. I find out that I can no longer buy that book for $20, as I have a competitor who bought the book for $20.25 and sold it for $20.75 to the student wanting the book. The arbitrage opportunity declined by 50 cents. Since it's still an attractive investment opportunity, eight other students also compete, and soon the arbitrage opportunity is pretty much gone.
This 10-fold increase in competition is exactly what has happened, with hedge funds growing from $200 billion in 1997 to $2 trillion today.
This presented a dilemma for hedge fund managers, who wanted to make serious money and weren't satisfied with the paltry 2 percent annual fee. The solution? Take as much risk as possible with their clients' money. That extra risk entailed investing more in options and futures, which are all zero-sum games and where not a penny in the aggregate had ever been made. These alternative assets had far less to do with investing and were much more similar to betting on a football game.
Why the hangover continues
With most investments, you can take you licks and move on. Not so with hedge funds. I've had many clients who thought they could get their money back at any time, until I pointed to page 173 of the prospectus and the section where the fund manager has the right to limit or deny the withdrawal request. In some cases, years later I'm still trying to help clients get their money back from hedge funds. Being ahead of the curve helps, as I was successful in getting clients out of The Endowment Fund sold by brokerage houses before they "gated" withdrawals.
So while hedge funds have been a disaster for most investors, managers are still raking in the fees by limiting withdrawals. In short, these funds are an outstanding gig for the manager but not so good for the investor.
As author and money manager William Bernstein says, "there is no portfolio fairy" willing to magically reward upside and protect downside. Further, he says, "if you are at the poker table wondering who the patsy is, it's probably you."