Q. Should I invest in a hedge fund?
A. The SEC has reversed an 80-year ban and will now allow hedge funds to solicit deposits not only from sophisticated investors who can afford to lose money, but from any investor who meets a minimum standard of $1 million in net worth or annual income of $200,000 but with no advanced financial knowledge at all.
Should you invest in a hedge fund? First, you need to understand what is a hedge fund.
What is a hedge fund and how are they different from mutual funds?
People talk about hedge funds as if they are an asset class, like stocks or bonds. In reality, this is not the case. Hedge funds can take investment positions in almost anything: stocks, bonds, derivatives, commodities, foreign currencies, and collectibles. Not only can they make bets for and against a wide variety of assets, hedge funds often use leverage (borrowed money) to amplify the impact of their trading decisions. Aside from their extremely broad latitude on how to invest, they are different from mutual funds in several other important ways.
Hedge funds can be purchased only by accredited investors, defined as those with a minimum net worth, excluding their home, of $1 million and income over $200,000 per year. The theory here is that high-net-worth investors are "sophisticated" and therefore able to correctly evaluate investment risk. It is worth noting that these limits were established in 1982; if adjusted for inflation, the net worth requirement would be $2.3 million.
Hedge Fund Costs
Hedge funds are, as Warren Buffett has concluded, not really investment vehicles but "compensation schemes." Unlike mutual funds, hedge fund fees are quite high and have typically been around 2% per year plus 20% of profits. (The Wall Street Journal reported recently that fees are declining to 1.8%/18% due to pressure from disappointed investors over the past few years.) You might think having the fund managers keep a percentage of the profits is a good idea because they will be incentivized to make profits. However, since the managers don't participate in losses, they are really just incentivized to take more risk. If things work out, they get their 18%-20% bonus; if not, oh well. It's a great deal for the hedge fund managers: Heads, you win and they win. Tails, you lose and they still win.
Hedge fund returns are often quite volatile, much more so than typical stock mutual funds, due to their use of derivatives and leverage, as well as their willingness to "go all in" on an idea. As a result, investment results are often really good or really bad. It is easy to see how hedge fund manager compensation would encourage that outcome. If the fund does well, the managers get a great payday. If it does poorly, the managers still get their 2%. They can liquidate the fund, return whatever is left back to investors, and then start a new hedge fund.
Liquidity and Transparency
Investors in mutual funds have access to their money on a daily basis (liquidity), whereas hedge fund investors are typically restricted on when they can withdraw funds. There have been many instances in which investor withdrawals have been completely suspended for months and even years.
Mutual fund investors enjoy a relatively high level of transparency with respect to how their dollars are being invested. Hedge funds, on the other hand, make very limited disclosures, and investors may not know what their fund owns. We know that asset allocation determines the risk in an investment portfolio. When you invest in a hedge fund, you lose control over your asset allocation decision.
The real selling point for hedge funds, of course, is their supposedly better investment returns. Everybody is looking for the "holy grail" of investing: the thing that will make them outsized returns. The differences described above between hedge funds and mutual funds (volatile returns, concentration in a few holdings, lack of liquidity and transparency) are important risk factors that an investor should be compensated for taking. So the question isn't just "Did the hedge fund outperform stock indices?" Instead, the relevant question is "Did the hedge fund outperform stocks by a wide enough margin (after fees) to compensate investors for the additional risks they took?" This is a pretty high hurdle.
Hedge Fund Returns
Let's look at some facts about hedge fund returns:
The HFRX Global Hedge Fund Index, the leading industry benchmark of hedge fund returns, has underperformed almost all equity indices over almost all time periods. Furthermore, there is a great deal of bias in the hedge fund statistics, which artificially inflate the index results. For example:
1. Survivorship Bias: The hedge funds that fail due to poor performance aren't in the index.
2. Self-Selection Bias: Poorly performing hedge funds often choose not to report their data.
3. Liquidation Bias: Hedge funds tend not to report performance in their last year of operation, often because they are losing money.
4. Backfill Bias: This occurs when hedge fund managers choose not report fund performance of a new hedge fund until and unless they have some successful performance. Then they "backfill" the database later with the successful performance.
Studies on the validity of hedge fund index performance estimate that these biases inflate the hedge fund index returns by anywhere from 4.4% to 7.5% per year!
Predicting Future Hedge Fund Returns
The hedge fund index numbers mentioned above are averages and certainly don't mean that all hedge funds have underperformed. There have been highly successful hedge funds that have made a lot of money for their investors. Unfortunately, you can't identify the good ones in advance, and neither can anyone else. Education, experience, and pedigree are no guarantees - Wall Street is littered with managers who have failed spectacularly after years of equally spectacular success. The truth is, past performance is no guarantee of future performance. Sound familiar?
So, why hedge funds at all? Well, running a hedge fund is an extremely lucrative business to be in. According to a recent book by Simon Lack, if you measure the total investment profit of the hedge fund industry (about $49 billion), 84% was kept by the industry (hedge fund managers), which leaves just 16% for the investors. Given these numbers, it is easy to see why there is such a proliferation of hedge funds and why there is so much interest in broadening the investor base through advertising to the public.
Do you still want to invest in a hedge fund?
A. The SEC has reversed an 80-year ban and will now allow hedge funds to solicit deposits not only from sophisticated investors who can afford to lose money, but from any investor who meets a minimum standard of $1 million in net worth or annual income of $200,000 but with no advanced financial knowledge at all.
Should you invest in a hedge fund? First, you need to understand what is a hedge fund.
What is a hedge fund and how are they different from mutual funds?
People talk about hedge funds as if they are an asset class, like stocks or bonds. In reality, this is not the case. Hedge funds can take investment positions in almost anything: stocks, bonds, derivatives, commodities, foreign currencies, and collectibles. Not only can they make bets for and against a wide variety of assets, hedge funds often use leverage (borrowed money) to amplify the impact of their trading decisions. Aside from their extremely broad latitude on how to invest, they are different from mutual funds in several other important ways.
Hedge funds can be purchased only by accredited investors, defined as those with a minimum net worth, excluding their home, of $1 million and income over $200,000 per year. The theory here is that high-net-worth investors are "sophisticated" and therefore able to correctly evaluate investment risk. It is worth noting that these limits were established in 1982; if adjusted for inflation, the net worth requirement would be $2.3 million.
Hedge Fund Costs
Hedge funds are, as Warren Buffett has concluded, not really investment vehicles but "compensation schemes." Unlike mutual funds, hedge fund fees are quite high and have typically been around 2% per year plus 20% of profits. (The Wall Street Journal reported recently that fees are declining to 1.8%/18% due to pressure from disappointed investors over the past few years.) You might think having the fund managers keep a percentage of the profits is a good idea because they will be incentivized to make profits. However, since the managers don't participate in losses, they are really just incentivized to take more risk. If things work out, they get their 18%-20% bonus; if not, oh well. It's a great deal for the hedge fund managers: Heads, you win and they win. Tails, you lose and they still win.
Hedge fund returns are often quite volatile, much more so than typical stock mutual funds, due to their use of derivatives and leverage, as well as their willingness to "go all in" on an idea. As a result, investment results are often really good or really bad. It is easy to see how hedge fund manager compensation would encourage that outcome. If the fund does well, the managers get a great payday. If it does poorly, the managers still get their 2%. They can liquidate the fund, return whatever is left back to investors, and then start a new hedge fund.
Liquidity and Transparency
Investors in mutual funds have access to their money on a daily basis (liquidity), whereas hedge fund investors are typically restricted on when they can withdraw funds. There have been many instances in which investor withdrawals have been completely suspended for months and even years.
Mutual fund investors enjoy a relatively high level of transparency with respect to how their dollars are being invested. Hedge funds, on the other hand, make very limited disclosures, and investors may not know what their fund owns. We know that asset allocation determines the risk in an investment portfolio. When you invest in a hedge fund, you lose control over your asset allocation decision.
The real selling point for hedge funds, of course, is their supposedly better investment returns. Everybody is looking for the "holy grail" of investing: the thing that will make them outsized returns. The differences described above between hedge funds and mutual funds (volatile returns, concentration in a few holdings, lack of liquidity and transparency) are important risk factors that an investor should be compensated for taking. So the question isn't just "Did the hedge fund outperform stock indices?" Instead, the relevant question is "Did the hedge fund outperform stocks by a wide enough margin (after fees) to compensate investors for the additional risks they took?" This is a pretty high hurdle.
Hedge Fund Returns
Let's look at some facts about hedge fund returns:
The HFRX Global Hedge Fund Index, the leading industry benchmark of hedge fund returns, has underperformed almost all equity indices over almost all time periods. Furthermore, there is a great deal of bias in the hedge fund statistics, which artificially inflate the index results. For example:
1. Survivorship Bias: The hedge funds that fail due to poor performance aren't in the index.
2. Self-Selection Bias: Poorly performing hedge funds often choose not to report their data.
3. Liquidation Bias: Hedge funds tend not to report performance in their last year of operation, often because they are losing money.
4. Backfill Bias: This occurs when hedge fund managers choose not report fund performance of a new hedge fund until and unless they have some successful performance. Then they "backfill" the database later with the successful performance.
Studies on the validity of hedge fund index performance estimate that these biases inflate the hedge fund index returns by anywhere from 4.4% to 7.5% per year!
Predicting Future Hedge Fund Returns
The hedge fund index numbers mentioned above are averages and certainly don't mean that all hedge funds have underperformed. There have been highly successful hedge funds that have made a lot of money for their investors. Unfortunately, you can't identify the good ones in advance, and neither can anyone else. Education, experience, and pedigree are no guarantees - Wall Street is littered with managers who have failed spectacularly after years of equally spectacular success. The truth is, past performance is no guarantee of future performance. Sound familiar?
So, why hedge funds at all? Well, running a hedge fund is an extremely lucrative business to be in. According to a recent book by Simon Lack, if you measure the total investment profit of the hedge fund industry (about $49 billion), 84% was kept by the industry (hedge fund managers), which leaves just 16% for the investors. Given these numbers, it is easy to see why there is such a proliferation of hedge funds and why there is so much interest in broadening the investor base through advertising to the public.
Do you still want to invest in a hedge fund?
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