It has been said that a sucker is born every minute. What hasn’t been said is that many of those suckers are also known as “qualified investors”— people with a net worth of $1.5 million or more. I say this because hedge fund investments are limited to qualified investors. The massive growth (and recent resurgence) of hedge funds is strong evidence that a sucker really is born every minute.
If investing in expensive mutual funds is a self-defeating exercise you’ve enjoyed, here’s a tip. You can get more futility, faster, with a hedge fund. While the fees and share of profits is a great deal for hedge fund managers, they offer scant rewards for investors.
This does not mean hedge funds are utterly useless. Hedge funds are useful for party conversation. They can also be a subtle way to tell people you’re in the seven-figure league. Equally important, you may learn if the person with whom you are speaking is in the seven-figure league. That’s about where my list ends.
Why am I telling you this?
Well, you might be a qualified investor. You might be thinking about buying into a hedge fund. On the other hand, if you are the kind of small investor regularly abused by Wall Street, you may find some relief in knowing that Wall Street is an equal-opportunity-abuser. They do bad things to Big Dogs, too.
One way to understand what a bad deal hedge funds are is to compare them to casino games. According to gambler John Patrick, the “vig”— the amount the house takes on each betting cycle— in games like Baccarat and Blackjack is just more than 1 percent. This transfers your wealth to the casino in due course, but it takes time. The real suckers in casinos are at the slot machines. That’s where the house take is about 13 percent of the average lever pull. Wealth is transferred very quickly this way.
A typical hedge fund will have a management fee of 2 percent (sometimes 3 percent) and will take 20 percent of any profits. More of the return is lost in other expenses, estimated in some studies at 2 percentage points a year.
Today, stocks yield less than 2 percent. This means the hedge fund (the house) takes all the income in fees, even if we forget about those other expenses.
This leaves the qualified investor with possible growth and all the risk. Corporate income, long term, has grown at about 6 percent a year. Ultimately, we hope to see this reflected in the stock price. A hedge fund gets 20 percent of that growth, or 1.2 percent. This leaves you with 4.8 percent before taxes and inflation. Since hedge funds do a lot of short-term trading you’ll likely pay at least 1.2 percent in taxes. This cuts your net down to about 3.6 percent. Since 1950 the annualized rate of inflation has been about 3.8 percent.
So if the hedge fund manager gets 3.2 percent of the 8 percent total return (2 percent in dividends plus 6 percent growth), he’s getting 40 percent of the total return. That’s about 3 times what a casino takes from its slot-playing suckers.
An astute hedge fund salesperson could quite correctly argue that this isn’t an apples-to-apples comparison. Casino games are sum-zero games (actually sum-minus games when you figure the vig taken by the house). This means they are about transfers of principal from one player to another, and to the house.
Investing in stocks, long term, has been a sum-plus game. The hedge fund casino is only taking a large portion of the return earned on your principal, not your principal.
Hedge fund managers overcome this advantage by leveraging their portfolios with debt. Debt increases risk, so you’ll win big (maybe) or lose big (more likely). One indication you will lose big is simple. Most hedge funds die young. Researchers Burton Malkiel and Atanu Saha found, in 2005, that less than 25 percent of all hedge funds in 1996 were still around in 2004. This produces, they estimated, a huge “survivor bias” in reported hedge fund returns since the records of the failing hedge funds are quietly buried with them.
Over the last eight years the most commonly referenced index of hedge fund performance, the HFRX Global Hedge Fund Index, has trailed the return of the S&P 500 seven times. Over the last 4 years the S&P 500 beat the hedge fund index 3 times— and hedge funds are supposed to thrive in bad markets.
On the web:
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(c) A. M. Universal, 2011