If you’ve heard people are making a killing in hedge funds, you heard right. The operators of hedge funds earn oversized fees year in and year out. Their investors, not so much. What do the hedgies do to earn the big fees? This is one of investing’s most baffling mysteries.
Hedge funds are essentially mutual funds without a curfew. Because they can only be sold to “sophisticated investors,” hedge funds have more latitude to use leverage, sell securities short, and make other kinds of bets that are not available to their more tightly regulated investment kin.
At what price mediocrity?
There’s also a big pricing difference. Hedge fund managers charge a stiff management fee each year. Two percent is the norm. In addition, they take a share of profits in any year when they produce a positive return. Twenty percent is the norm, and the take can run as high as fifty per cent. They do not pay a penalty for a negative return. By comparison, an actively managed mutual fund might charge .8 to 1.5 percent annually. Meanwhile most index ETFs, our vehicle of choice, charge 5-25 basis points, or even less.
So for these high fees, what do investors get? As recent articles describe, they get pretty humdrum performance and a lot of mystery. In his New Yorker piece, John Rich writes that hedge funds have delivered approximately the return of the S&P 500 since 1994.
Rich debunks the idea that hedge funds outperform the markets, as well as other often heard assertions, such as their better risk-adjusted or uncorrelated returns. Ultimately his article, ‘How Do Hedge Funds Get Away With It?’ and Noah Smith’s Bloomberg piece, ‘Hedge Funds Won’t Make You Rich’ point to perception – or misperception, perhaps – as the prime justification for premium fees.
Better an owner than an investor
The arithmetic of hedge fund returns overwhelmingly favors the owner-operators. Hedgies can make a lot of money for themselves. How much? The 25 highest paid hedge fund moguls took home $21 billion for themselves in 2013. David Tepper led the pack with $3.5 billion. Steve Cohen came in second at $2.4 billion. The feast in the hedge fund trough each year is the subject of great fascination and much tut-tutting.
Perception won’t pay off the mortgage
Hedge funds are seen as jet fighters in a prop plane industry. They’re expensive, freewheeling, and hard to get into – many require high minimum investments. It’s this velvet rope treatment that signals greater quality to many investors. Like the hottest new restaurant with a full reservation book, those on the outside looking in don’t care what it costs; the exclusivity alone justifies the pricey fare.
Across most markets investors and regulators have cried out for more transparency in recent years, but in the hedge fund world the general lack of transparency seems to be part of its value proposition. Perhaps the less some of us know about a product the more willing we are to view it as valuable. It doesn’t make sense to me personally, but who am I to judge?
In my experience, despite all the enthusiasm for hedge funds and supposed great returns, I have never met an individual investor who put enough in hedge funds (at least 30% of one’s portfolio) to make much difference. For my money, except for operators, hedge fund investments remain great cocktail party chatter. We’ll stick with index ETFs here.
John Osbon – firstname.lastname@example.org
This communication may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.”
“Historical performance is not indicative of future results. The investment return will fluctuate with market conditions.
Past performance is not indicative of any specific investment or future results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor.
Investment strategies, philosophies, allocations and holdings are subject to change without prior notice.
This communication is intended to provide general information only and should not be construed as an offer of specifically tailored individualized advice.
While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.
Adviser does not endorse the statements, services or performance of any third-party vendor.
Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.
Any IPO alerts are purely informational and should not be construed as recommendations to invest.
Adviser is not licensed to provide and does not provide legal, tax or accounting advice to clients. Advice of qualified counsel or accountant should be sought to address any specific situation requiring assistance from such licensed individuals.
Any case studies or hypothetical client profiles are for demonstration purposes only. They illustrate the breadth and depth of the many clients we represent at various life stages. Any similarities to actual Adviser’s clients past or present are strictly coincidental. Individual advice and results will vary based on each client’s circumstances, objectives and prevailing economic conditions.