My mother frequently asks me what money secrets doctors have. From her perspective, doctors mysteriously create financial success using techniques unavailable to anyone else. I point out to her that doctors invest heavily in education, work very hard to earn relatively high salaries over many years, become well-established in their communities and invest and diversify over the long term. In short, there is no magic, and for the most part financially successful doctors follow the basic principles available to anyone.
Hedge funds have developed a similar mystique, driven by their traditional availability for wealthy investors only. And some hedge funds have produced spectacular returns. This combination has produced an explosion in hedge fund assets to over $1 trillion and new hedge fund products that are available to more investors. (After the technology bubble burst, the SEC discussed whether mutual funds should use the techniques employed by hedge funds, which did not suffer similar losses. This performance advantage was short-lived and the idea went nowhere.)
Of course, the decision to invest in hedge funds should not be made on hype alone, and it is important to understand that a hedge fund is essentially an unregulated investment pool with very broad investment powers (a mutual fund is a more closely regulated pool with a specific investment strategy and lower fees). “Hedge” implies that the fund has the potential to profit in any market environment. In practice, hedge funds often use “leverage”, or borrowed money, to increase their investment exposure, magnifying both gains and losses.
A closer look at hedge funds makes reveals more causes for concern. Funds are not required to reveal their holdings, performance information, asset allocation or other information. While fund managers claim this secrecy is necessary to protect their proprietary strategies, it makes it impossible for an investor to really evaluate the risk of the investment. Essentially the investor writes the check and hopes the hedge fund performs well.
A hedge fund has to perform exceptionally well to make up for its high fees. Unlike mutual funds and traditional investment managers, hedge fund managers typically take 20% of profits in addition to a fixed management fee. When a fund does not perform well, and the manager sees little prospect to make up lost ground to earn these high fees, the fund can simply decide to liquidate and return investors’ money at its current value. It is no surprise that to justify such high fees and produce attractive after-fee returns, many hedge funds are becoming speculative.
After not telling you how your money is invested and taking 20% of any profits, most funds have restrictions on withdrawals. It is not uncommon to only allow quarterly or less frequent withdrawals, and in-demand managers can require that money invested in a new fund not be withdrawn for as much as two years.
A new development is “funds of hedge funds” which invest in a poll of separate hedge funds. These funds of funds offer lower minimums and greater diversification, but their fees are not necessarily lower and the diversification, while reducing volatility, eliminates the chance for a home run.
While some practices of mainstream mutual funds have come under scrutiny lately, the lack of investor protection in hedge funds has resulted in some true fiascos. In 1998 Long Term Capital Management made a huge bet that went bad, requiring Federal Reserve intervention to prevent a worldwide financial crisis. In the last year alone three hedge funds have collapsed due to improprieties and at this writing Bayou Management may have as much as $400 million unaccounted for.
Are the returns worth it? Because of reporting inconsistencies this is a difficult question to even answer. Ibbotson Associates in Chicago analyzed the returns of 3500 hedge funds from 1995 through the first quarter of 2004. The results showed that fund management was a positive factor, improving hedge fund returns. Overall hedge fund performance, however, was 12.8% annualized for the period, compared to 12.1% for the S&P 500. After an estimated 3.8% in fees, hedge fund investors were left with roughly a 9% annual return.
The restrictive features of hedge funds are precisely why they were originally offered only to wealthy investors who could afford high fees, lack of transparency, lack of investor protection and limited liquidity. The rest of us should be careful to resist the hype and not be lured into a long-term commitment that likely won’t be the solution to our short-term anxiety anyway. As with the doctors, there is no magic to achieving financial success, just patience, persistence and discipline.