The SEC is making a mistake


(MoneyWatch) COMMENTARY The Securities and Exchange Commission just proposed letting hedge funds go from soliciting individual investors behind closed doors to conducting wide advertising campaigns without restrictions. If it goes through with this, it'll be giving poor investments a wider net to ensnare investors.

The SEC voted 4-1 to seek public comment on the proposal, which would formally lift a ban on hedge funds marketing their investments to a wide audience. The public has 30 days to comment, after which the regulatory agency will likely take a final vote. Hedge funds still would be required to sell securities only to investors with a net worth of at least $1 million excluding their primary residence, or those earning more than $200,000 a year.

In a June speech, the SEC's director of investor education, Lori Schock, stated: "These offerings are not for everyone and carry a very high degree of risk. For every successful venture, there are more numerous failed ventures."

The evidence suggests that this is the understatement of the century.

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The performance of hedge funds demonstrates very clearly that they aren't investment vehicles, but rather compensation schemes designed to transfer assets from the wallets of unsophisticated investors to the wallets of the purveyors. For the past one, three and five years ending July 2012, the overall HFRX Global Hedge Fund Index produced annualized returns of -5.2 percent, 1 percent and -3.4 percent per year, respectively. We can compare these returns to two simple benchmarks:

  • The S&P 500 Index for stocks
  • A five-year Treasury index for bonds

For the same one-, three- and five-year periods, the S&P 500 returned 9.1 percent, 14.1 percent and 4.4 percent per year, respectively. And five-year Treasuries returned 4 percent, 6.1 percent and 6 percent per year, respectively. And for the period 2003-2012, the HFRX index underperformed every single major stock and Treasury bond index, while exposing investors to far more risk.

What the SEC fails to understand is that having significant wealth doesn't automatically qualify people as sophisticated investors. If it did, the hedge fund world would be a lot smaller.

If wealthy investors want to foolishly transfer their assets to hedge fund managers, shame on them for not doing their homework and investing in things they don't understand. But one can only wonder what the SEC is thinking in moving to allow hedge funds to advertise. As David Swensen, the chief investment officer of the Yale Endowment, once said said: "Thievery, even when dressed in the cloak of SEC-approved governance, remains thievery... as the powerful financial services industry exploits vulnerable individual investors."

Here's what Swensen had to say about investing in hedge funds: "In the hedge fund world, superior active management constitutes a rare commodity."  He added:

Understanding the difficulty of identifying superior hedge fund investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating active management results. When operating in arenas that depend fundamentally on active management for success, ill-informed manager selection posses grave risks to portfolio assets.

Image courtesy of Flickr user purpleslog

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.