Hedge Funds – Are They Right for You?

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Hedge Funds – Are They Right for You? I have often said that if there was a perfect investment allocation it would have to be 60 percent in equities and 40 percent in fixed. This allocation has historically provided the growth needed to keep pace with inflation and enough in fixed to take the investor through the bad markets, although every investor’s situation is unique. Many advisers questioned the wisdom of this allocation after the dot com bubble of 2000-2002 and then the great panic of 2008. There have been many articles published by advisers talking about the advantages of hedge funds and alternative investments as a way to protect against a future down market.

New research shows you would have been better off sticking with the 60/40 allocation. Bloomberg has recently released data showing that hedge funds have trailed the return of a 60/40 mix over the past five years1 . The Bloomberg hedge-fund index (BAIF) tracks 2,697 funds2 . The group lost 2.2% over the 5-year period while the 60/40 allocation fund gained 3 ½% annually. The 60/40 allocation also beat the main Bloomberg hedge-fund index in six of the last seven calendar years.

Hedge funds have grown assets to a record $2.1 trillion despite the mediocre performance. Some attribute the weak performance to the high fees normally paid to hedge fund managers. The standard fee of 2 percent of assets and 20 percent of profits adds up quickly. Simon Lack, author “The Hedge Fund Mirage“, says weak performance could also come from the fact that there aren’t as many opportunities available because hedge funds have raised so much money.

The argument for hedge funds centers on their ability to protect principal in down markets. From the end of 2000 through 2002, a 60/40 allocation lost 6.3% when hedge funds returned 6.7% annually, according to data from Hedge Fund Research Inc. (HFRI). Data compiled by Bloomberg also shows hedge funds narrowly beat a 60/40 allocation in 2008 when the allocation declined 22% and hedge funds lost 19%.

There is not a lot of long-term data on hedge fund performance to do a more complete analysis. A study commissioned by the hedge fund industry’s trade group found that hedge funds outperformed a mix of stocks and bonds from 1994 to 2011 by 1.6% per year. The study’s results equally weighted funds regardless of size. Critics of the study say asset-weighted indexes better reflect the actual returns achieved by investors. Since 1998, HFRI’s asset-weighted index trails the performance of its equal- weighted index by about 1.6% a year leading critics to believe the return would be the same for a 60/40 allocation3 .

Hedge funds are not new. They’ve been around a long time. What makes them the darling of today’s investment world to some is the 2008 panic/financial crisis and the role they played in that event. 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 on bond defaults. 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 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 client. Databases on hedge funds are getting better but they still 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 sometimes removed from the database entirely. 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. When you take all this into consideration, I plan to stick with the 60/40 allocation.

1 Using a Vanguard index fund with a 60/40 mix for the 5-years ending 6/30/2012. The balance fund return is calculated net of fees.

2 BAIF Indices represent a composite of funds in the same peer group. This index represents all hedge funds, domiciled globally. Returns are reported net of fees.

3 The HFRI Indices are a series of benchmarks designed to reflect hedge fund industry performance by constructing equally weighted composites of constituent funds, as reported by the hedge fund managers listed within HFR Database. Returns are reported net of fees.

Rick’s Tips

  • Hedge funds are supposed to protect principal in a portfolio during down markets.
  • Hedge fund returns have been good in down markets but trail a 60/40 stock/fixed allocation over time.
  • Many experts believe the high fees charged in hedge funds eat up the return.

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