Hedge funds are a scam. Yes, I mean what I write. Hedge funds do not provide any benefit for the average investor.
The debate about hedge funds usually gets political. Democrats want more regulation, and Republicans want less regulation. There should be a certain amount of regulation, but Democrats usually turn the debate into a populist, idealist argument, without even really mentioning what hedge funds are. I am talking about an entirely different aspect here.
Let us first exam what hedge funds are. Hedge funds are investment firms set up by both small investors and large investors. The biggest hedge fund, Bridgewater Associates, has $125 billion of assets. The total industry has slightly over $2 trillion in assets. However, colleagues of mine run small hedge funds with assets of only a few million dollars.
Hedge funds are supposed to provide better returns than do stocks. They are also supposed to protect against risk. Since hedge funds can short stocks, they are supposedly a safer investment for investors. For example, hedge fund managers can do something called a “pair trade.” A simple example is as follows: if a hedge fund manager thinks Apple is a good stock, but is scared about the technology sector doing poorly, he can go long apple and short Google. If Google goes down 10 percent and Apple falls 5 percent, he still makes money.
The reason why hedge funds are bad investments is that it is a zero sum game. Hedge funds are part of the market, and, therefore, will provide market returns minus fees. If the Standard & Poor’s 500 Index is up 10 percent, hedge funds should be up 10 percent. But the fees are exorbitant, usually over 20 percent. So, the average hedge fund will, therefore, provide a total return of only 8 percent.
It is hard to find a good hedge fund manager. The best money managers usually are well-known and it is harder for them to beat the market. Warren Buffett says he could produce far higher returns if he managed less money. On the other hand, small hedge fund managers are less-tested. In terms of risk, no one can really define risk, so it is hard to say hedge funds produce a better risk-adjusted return (assuming there is even the data to support that).
A report is out today that further drives home the point that investors should not think hedge funds are the way the media portrays them.
Hedge Fund Research states that fewer hedge funds are at their high-water mark than at any time since the firm started their research. The high-water mark is something many hedge funds setup to align investor interests with the manager. If the manager loses $100,000 one year and then makes $50 million the next year, the manager would not be paid compensation for the gain. They would only get the money when the firm makes back the money it lost.
There is a lot of data out there on hedge funds being poor investments. This is just the latest to show that, in general, they are a scam.
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