The Mystery of Hedge Funds

The Wall Street Journal ran article on the front page a few weeks ago about how investors our pouring money into hedge funds. The Journal reported that hedge funds are managing nearly $2 trillion and are approaching the high point they reached in early 2008 before the economic crisis.

The recovery of the hedge fund industry is baffling. This industry claims to provide investors with returns that are better than those that can be achieved though such pedestrian vehicles as mutual funds. Hedge funds market themselves as sophisticated, exclusive, and elitist. They cater to the affluent investor who must meet the accredited investor standard. (According to the Securities and Exchange Commission, these investors must have an income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. Alternatively, the investor must have a net worth that exceeds $1 million.)

Apparently many accredited investors are not particularly intelligent investors. If they were, they would realize that hedge funds have generally failed to live up to their claims. In 2008, hedge funds suffered their worst year on record with the average fund losing 19% according to Hedge Fund Research Inc.

As a result of losses and withdrawals the hedge fund industry shrank by a quarter. But the industry has rebounded and attracted $55.5 billion in net new money in 2010.

Now the average hedge fund earned 20% in 2009 and 10.3% in 2010. The Standard & Poor's 500 index increased 26.5% and 15.1% in those same periods. In the first quarter of this year, the average hedge fund rose 1.6% in the first quarter of this year compared to 5.4% for the S&P 500 index.

One has to wonder about investors who pour billions in to vehicles that routinely underperform the market. It's even more perplexing to consider that most of these hedge funds use strategies that carry risk that is far greater than the risk of the market itself. So, investors take on more risk than the market and are rewarded with lower returns than the market.

It does not end there. Hedge funds typically charge their investors a 2% management fee and they take 20% of the profits. I don't know how Hedge Fund Research reports their data. It could be before or after fees. If it's before fees, then hedge funds are even less appealing.

Intelligent investors don't accept the hype surrounding hedge funds. They are smart enough to ask serious questions before investing in anything, including hedge funds. Questions like:
How much risk is involved in this investment?
What is your performance benchmark?
How have you performed against that benchmark?
What fees will I be paying?



Sources: The Wall Street Journal, Hedge Fund Research