The Investment Scientist

A Balanced Portfolio to Avoid (II): Hedge Funds Don’t Deliver Outstanding Returns

Posted on: April 28, 2011

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.

2 Responses to "A Balanced Portfolio to Avoid (II): Hedge Funds Don’t Deliver Outstanding Returns"

Buying into a hedge fund is like buying a Yugo for $102,000. You’re paying about seventeen times the average rate for lower than average performance. To put it another way, the investor is taking all of the risk and paying about 50% of return in an average year to someone who takes none of the risk. Even if the hedge fund manager is investing 100% of his own portfolio into that same fund, his salary from clients will always make up for any losses.
Hedge fund: (7% average stock market return * 0.8) – 2% = 3.6%
Index fund: 7% – 0.2% = 6.8% (with lower taxes and trading fees)
Hedge fund break-even: 11.0% (11.0 * 0.8) – 2% = 6.8%
In order for a hedge fund to break even with my low cost index fund, the fund manager would have to consistently outperform the average market return, year after year, by over 57% (11/7). This would be headline news in financial newspapers & websites. It is not happening. This is yet another triumph of marketing over common sense and self-interest. While harsh, it is also truthful to say that the financial industry is in general self-serving and dishonest. I read the Investment Fiduciary and Allan Roth’s columns because of your honesty. You show that it is possible to remain ethical while making money. Thank you.

Jerry,

Thank you for the kind words. Indeed if there is a scale of 1 to 10 with 1 being very dishonest and 10 being very honest, the financial industry overall is probably 1 or 2, while Allan Roth is unquestionable 10. I hope people will see me as closer to Allan than the financial industry.

Michael

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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