Hedge or Hoax

Strategy after strategy has failed to produce the returns promised or mitigated the risk.

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After two and a half decades in the investment-advice business, I’m still amazed by how often the same patterns repeat themselves. For example, Wall Street continues to create new – and allegedly better – ways to invest. These new, “sophisticated” methods of investing are designed around the same goals – higher return with less risk. The lessons that investors ultimately learn from this can be found in history books – there is no such thing!

In the 1980s, it was option-income strategies, followed by portfolio insurance. Both promised the upside of the stock market with limited downside. These strategies crashed and burned in the 1987 stock-market crash.

Hedge fundsThen, government-plus funds were the rage, promising higher returns while having the safety of government securities. Neither “promise” turned out to be true.

Multi-sector bond funds made the same claims in the early 1990s. It turned out the currency-exchange risk could not be hedged as effectively as the computer models claimed it could be.

I could go on and on as strategy after strategy has failed to produce the returns promised or mitigated the risk. The pattern typically follows a huge upheaval in the market. This brings us to 2011 and the sophisticated investment du jour – the hedge fund.

Hedge funds are not new. They’ve been around a long time. What makes them the darling of today’s investment world is the 2008 panic/financial crisis and the role they played in those events. Such books as Michael Lewis’ The Big Short highlighted how some hedge funds speculated on the collapse of the mortgage bond market and made a fortune as a result of betting against the market. That is what a lot of hedge funds do. They speculate in a big way in some part of the market and to the extent they are right, as huge profits are reported. Unfortunately, this does not mean they will ever be able to repeat that success.

The argument for hedge funds today is that they diversify your risk against another stock market crash. Hedge funds have the ability to short the market so they would actually appreciate when the stock market goes down. The problem is that there is little evidence they have actually been able to do this over time and produce results that are better than investing in traditional asset classes. They generally involve: 1) using large amounts of borrowed money; 2) making concentrated bets; 3) trading excessively; and 4) relying heavily on subjective forecasts. This doesn’t sound like a way to reduce risk.

The other argument I’ve heard is that hedge funds are exclusive and only for sophisticated investors. The net-worth requirement would make them more exclusive, but that still doesn’t mean they are better investments. Some brokerage firms bundle these strategies into a fund-of-funds and market it as a way to participate in these exclusive, sophisticated strategies. The evidence so far has shown that on average, fund-of-funds have underperformed. Just because an investment is hard to get does not mean it is a good investment – or more importantly, that it is appropriate for you.

The most common characteristics of hedge funds are

  • Fees – manager compensation is high. The typical fee schedule is referred to as two and 20. This means two percent of the assets under management plus 20 percent of the profits.
  • Leverage – borrowed money is often employed to magnify returns.
  • Liquidity – it is a lot easier to get into a hedge fund than it is to get out. There are usually time restrictions (such as you can only withdraw your money at the end of a calendar quarter) and amount restrictions, which prevent you from taking all of your money out at one time.

I’ve been following hedge funds for years, looking for some way to track performance accurately to determine if I should recommend them to my clients. Databases on hedge funds have many problems. Managers only provide return information when they want to, which usually means only when the numbers are good. Hedge funds with poor performance are closed quickly and the results are removed from the database entirely. So far, attempts to adjust for these problems have shown that hedge-fund returns are far lower than reported.

According to the Journal of Financial Stability, the median life of a hedge fund is only 31 months. Fewer than 15 percent of hedge funds last longer than six years and 60 percent of them disappear in less than three years. Pension & Investments reported that 784 new hedge funds were started in 2009, while 1,023 existing funds were closed. The odds of picking the next successful hedge fund are probably comparable to a trip to Atlantic City. This is why I have never recommended a hedge fund to my clients.

This article originally appeared in Lancaster County magazine.

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