For some time we have been warning investors about the perils of investing in hedge funds.
So, the news about Bear Stearns bailing out two troubled hedge funds for $1.6 billion should not have come as a big surprise.
Press reports suggest other major hedge fund disasters are lurking around the corner.
For sure, not all hedge funds are bad. Some have offered incredible returns. But others have not lived up to their promise — or are based on flimsy investment schemes.
Worse — some are outright frauds.
Recently, we offered accredited investors a special report in our Private Opportunities newsletter about how to evaluate a hedge fund.
Claims of 20 percent or 30 percent or more in annual returns from equity investments are astounding and are usually preposterous if made over a long period of time.
Remember that even the greatest stock pickers, like Warren Buffett have only demonstrated annual gains of less than 15 percent per annum over decades of investing. [By buying and controlling subsidiary companies, Buffett has done better, in the 20 percent range.]
Remarkably, many of these hedge funds, as our expert John Browne says, "Don't hedge."
Hedge funds in theory were suppose to be investments where your money managers bet on investment vehicles like a stock, but then using derivatives to "hedge" the investment to limit down-side risk.
Nowadays, hedge funds can be investing in things like works of art and antiques. How does one hedge a Picasso?
Since our Private Opportunities report on hedge funds was released, the news continues to be bad for hedge funds.
Businessweek reports in its July 9 edition that the "next big scandal" coming on Wall Street is how hedge funds and investment banks have colluded using privileged information to profit — schemes that the magazine says will show profits "have been ill-gotten."
And with the Bear Stearns news, more media outlets are over turning rocks and have been looking past the hype about hedge funds.
A recent feature piece in the New Yorker by John Cassidy reports that several economists say many of the high returns claimed by hedge funds are simply inflated.
Cassidy notes that in the last 15 years, the number of these privately owned hedge fund companies has risen from around 500 to as many as 10,000.
Investor money is pouring into these funds for "alpha" returns larger than you can expect to make investing in any broad market index.
Two economists cited by Cassidy — Burton Malkiel of Princeton and Atanu Saha, an investment analyst — found many of these claims of alpha returns are simply bogus.
When poorly performing funds that closed were counted in for analysis, the economists found that hedge funds overall made an average return of just 9.32 percent between 1996 and 2003, compared to the claimed 13.74 percent for funds that have their results published for public scrutiny. In other words, many funds are claiming about 50 percent more than actual performance.
And in 2006, most hedge funds didn't even match the near 16 percent gain in the S&P 500.
Who is getting rich here?
Start with the hedge fund managers who typically get a 2 percent management fee of total funds invested, plus 20 percent of any profits. If you lose, they win no matter what.
Not a bad deal for the managers!
Again, not all hedge funds are bad. Investors must be very careful in scrutinizing their investments and never put all their eggs in one hedge fund basket.
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