A Balanced Portfolio to Avoid (II): Hedge Funds Don’t Deliver Outstanding Returns
Posted April 28, 2011on:
Hedge funds are often peddled as a unique asset class that has outstanding returns that are uncorrelated with the market. In reality, hedge funds are as much an asset class as Las Vegas is.
Hedge funds are a general description of private investment companies that are organized as limited partnerships with fund managers as the general partners and investors as limited partners. The keyword here is private. By law they are not supposed to be sold to the public; therefore, they are exempted from government oversight. But sold to the public they are! It is not the first time unscrupulous “financial advisors” have pushed the limit of the law, while the SEC looks the other way.
Hedge funds have exorbitantly high fees. The typical fee structure is 2/20, that is a 2% management fee and a 20% performance fee. To be worthy of the fees, the fund manager has to perform like Michael Jordan on the basketball court. The problem is: there are few Michael Jordans in the hedge fund world, but there are many pretenders who charge like him.
In 2005,Princeton economics professor Burton Malkiel published a study titled “Hedge Funds: Risk and Return.” After examining hedge funds in-depth, he concluded:
Hedge funds are riskier and provide lower returns than commonly supposed.
The result is not surprising to me. You don’t know what hedge fund managers are investing in, how they invest their clients’ money, and how much leverage they use. If they have a good year, they will raise a triumphant banner for all to see. When they lose all their clients’ money, they quietly close down and start another fund.
Next time a financial advisor tries to sell you a hedge fund with “superior performance,” ask yourself this question: if it is as good as he says it is, why isn’t he keeping it for himself and his close families and friends. After all, by law hedge funds are meant to be a private investment vehicle.