The Investment Scientist

Do you have “cancer” in your portfolio?

Posted on: June 7, 2009

“They are the cancer of the institutional investment world.” – David Swensen

Would you consider forming a partnership with someone you don’t know, in which you would contribute the money and that someone would conduct a business that you don’t understand, and do the accounting as well?

Most business owners would respond with a resounding “No!” The reason is obvious: such an arrangement is the surest way to lose money.

Yet, many of these same business owners would jump at the opportunity when presented with an “exclusive” offer to invest in a hedge fund that promises to make money in good times and bad through a magic “black box” formula.

They should know better. A hedge fund is a private investment partnership unregulated by the Securities and Exchange Commission (SEC). The hedge fund (unlike a mutual fund) does not have to register as an investment company, or the fund manager as an investment advisor. As a result, they are not required by the SEC to report their performance. If they make their performance public, it is often to attract investors. So, they can always “cut and paste” to create a more attractive performance.

Hedge funds are just like any other business: 90% don’t last more than three years, 9% survive, and 1% do exceptionally well. They are not bad things per se. As a matter of fact, the highly successful Harvard and Yale endowments put close to 20% of their money in hedge funds.

The key to the success of the Harvard and Yale endowments, however, is that they approach each hedge fund as a business venture. They usually know the hedge fund managers personally, they understand the formulas, they have rigorous due diligence before investment, and they hire their own accountants to audit the performance afterward.

Just because Bill Gates made a lot of money starting Microsoft does not mean we should all go out and start a software company. Likewise, just because Harvard and Yale make a lot of money investing in hedge funds does not mean the rest of us can or should do the same.

Unfortunately, there are organizations out there that thrive on attracting money for the bottom 90% of hedge funds from unsophisticated investors. (The top 1% of hedge funds don’t need help.) These organizations include the so-called funds of hedge funds, some multi-family offices, and some big Wall Street firms’ wealth management arms. Without them, Bernie Madoff wouldn’t have been able to made off $65 billion (no punt intended.) No wonder David Swensen called these organizations the cancer of the institutional investment world.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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