In A Word, "NO!"
Are Hedge Funds Worthy of Your Investment?
I've been following the hedge fund industry since I started in this business almost 18 years ago. It's amazing how this industry has evolved since then. And unfortunately, it's evolved for the worst.
Back in 1990, 610 hedge funds were operating with about US$39 billion in assets, according to Hedge Fund Research . Today, that number has mushroomed to over 9,000 hedge funds worldwide with an estimated US$1.3 trillion under management. That's an amazing bull market in asset growth!
Today, a huge wave of young and middle-aged professionals has left the big Wall Street and London's City high-finance firms to set up their own shop this decade. And who wouldn't be lured by the incredible fee structure? Hedge funds typically charge a 2% total expense ratio (management, audit, legal) plus a 20% incentive fee on net new profits, if any.
But here's a statistic that tips the balance in favor of traditional funds over alternative investments like hedge funds: In the 1990s, the average hedge fund gained 18.3%. That's pretty much in tune with the S&P 500 Index. But so far this decade, the average hedge fund has mustered a 7.5% annual return versus 2.5% for the S&P 500 Index.
To be sure, hedge funds protected capital in the worst bear market since the Nixon years from 2000 to 2002. But it's fair to say that when markets are rising, hedge funds not only fail to beat the market, they also provide poor liquidity, charge huge fees and increasingly, lock-up your money for at least six months and sometimes, up to five years.
For the record, though hedge funds held their own in the last bear market, an investor would have fared much better in REITs and long-term U.S. Treasury bonds -- without forking over those insidious fees.
And as my colleague Mike Burnick has pointed out , the large number of exchange traded funds available today makes it possible for you to closely imitate a hedge-fund investment strategy, but at a much lower cost.
Of course, some hedge funds belong in a diversified portfolio, especially those managers with a skill-based ability to engage in asset-backed lending, distressed debt, global long/short equity and convertible arbitrage.
Unfortunately, since most hedge funds are concentrated in the long/short equity category and do not actively engage in short-selling (most managers have no clue how to short-sell profitably), investors are paying an incentive fee to what is essentially a glorified stock mutual fund manager failing to beat the market in a good year for equities. And when stocks reverse, most long/short equity hedge funds follow the market south.
Today, hedge funds are a business more than anything else. And regrettably, it's the sponsors, not the investors, who ultimately earn the biggest returns.