Here Come the Hedgies!

If you have not already read this in the press, be forewarned that the SEC lifted an 80-year-old ban and will now allow hedge fund to solicit funds not only from sophisticated investors, but from any who meet a minimum standard of $1 million in net worth or annual income of $200,000.

There is a lot of concern in the industry (myself included) that these complex products will be sold aggressively to investors who don’t really understand the risks. Coupled with the high fees they charge, they should be irresistible to any red-blooded salesperson with a pulse. Given the war chests of some firms, we will also likely be seeing advertising. So why should we be cautious about investing in them?

Years ago I was encouraged to run a fund of these hedge funds, as my background includes a successful run in selecting investment managers. I did research on these funds as a class, and the following factors dissuaded me from attempting to introduce this type of product:

  • While hedge funds claim to be their own asset class, they really can only invest in existing markets. They can leverage (invest with borrowed money) and short securities (bet on them going down), but when you look at historical returns, they are surprisingly correlated with traditional asset classes. So the diversification benefit can be overstated.
  • They charge horrendously high fees.
  • They have hot and cold performance streaks that are unpredictable, just like traditional mutual funds. In other words, human nature and fallibility prevail. If performance consistency is an issue, and you don’t have an extremely large staff to stay on top of this universe of managers, you really don’t have any business investing here.
  • Transparency is a problem. While this is improving, with more funds becoming more forthcoming (especially those in mutual fund form), many remain opaque about what they are really doing with your money.
  • Hot money jumps out of these funds quickly. The investor base of many funds can be very fickle, which is not surprising when you consider the high fees. You don’t want to be the last investor out and be left holding the bag. This is especially important for funds that invest in illiquid securities. In 2008, many investors wanted out of their hedge funds, and they were prevented from exiting because of “gates” the funds put up preventing liquidations.
  • In aggregate, the record of hedge funds has been mixed; while they claim to have low correlations to the traditional markets, this meant that in 2008, you might have lost 20% of your money instead of close to 40%, and they did not rebound as strongly thereafter. If you expected a somewhat lower volatility approach, you were satisfied with those results, but if you were expecting absolute returns regardless of market environment, you were disappointed. P.S. A traditional portfolio did as well or better, depending on your asset allocation, and at much lower cost.

Please also know that while I continue to search for alternative investments with low correlation to traditional asset classes, they need to be available in a form that is transparent and as low cost as possible. They are specialized asset classes, many in ETF (exchange traded fund) or mutual fund format, rather than a hedge fund.