Tuesday, November 27, 2012

Hedge Fund Mirage

The highly respected magazine The Economist, printed an article on hedge-fund returns earlier this year. Guess what? They are horrible.  Thus, the name of the article is "Rich Managers, Poor Clients." The Economist article is based on a book called The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True.

Oh, hedge fund managers are indeed brilliant - they are masters at identifying inefficiencies in the market and taking advantage of the uninformed patsies.  Unfortunately, the most uninformed patsies seem to be the clients of the hedge funds themselves!  You see, while the hedge fund industry has made the hedge fund managers wealthy beyond belief, their clients have enjoyed a 14 year annualized return of about 2.1% or about half what you could earn investing in riskless treasury bills!

How can this be?  Every pension fund and endowment in America is piling into hedge funds.  How can the returns be so horrible?  Brace yourself, I'm going to use 3rd or maybe 4th grade math to explain the obvious problem with hedge funds.  What I'm about to tell you was not in The Economist article. Ok, are you ready?
Hedge funds have wildly high expenses.  That is all you really need to know, but I encourage you to keep reading.

By the way, a hedge fund differs from a typical mutual fund in that a hedge fund can bet that the price of a stock or bond can go down.  Since the manager can buy one stock and bet another stock will go down (a practice called "shorting") the manager is considered "hedged" against the overall market either going up or down.  This sounds reasonable in theory since most mutual fund managers will look at perhaps 10 stocks before finding even one that they like.  So, it makes sense to allow the manager to actually bet against the stocks she has already looked at and decided she hates.  The problem, as I stated above, is that hedge funds charge absolutely outrageous fees.  So, here come the numbers and basic math.

The typical fee arrangement for a hedge fund is referred to as "2 and 20."  The "2" portion actually is an annual fee of 2% of the assets under management.  This can be thought of as being similar to an expense ratio of a mutual fund.  The typical mutual fund expense ratio is around 1% or roughly HALF the expense ratio of the typical hedge fund.  But wait, that is not all.  The "20" part of the fee structure refers to the fact that after the manager charges you 2% of you money every year, he will also take 20% of any profits he produces after taking his fee.  Yeah, I'm not kidding!

So consider this:  There are a whole ton of economists and college professors and other market analysts (myself included) that believe we will be lucky to get 8% per year from the stock market going forward.  So, if you invest with a hedge fund, the fund will take 2% off the top leaving you with 6%.  But wait, he will take 20% of that remaining 6% (or 1.2%).  Thus, if your hedge fund manager is one of the rare ones that can actually keep pace with the market on a before fee basis, you can expect to net about 4.8% going forward.  Keep in mind that if you just bought an index fund you'd net about 7.9%.

So, if a hedge fund manager somehow managed to put up a huge number like 12% or 4% over the expected return of an index fund your net return would be as follows:  First, the manager would take his 2% annual fee  so you are down to 10% right away.  Then, he takes 20% of what profits are left.  So, 20% of 10% is 2%.  So, 12% - 2% -2% = 8%.

That's right, a hedge fund manager needs to beat an index fund by about 4% each and every year before his clients will begin to benefit over what they could earn by just buying an index fund.  What are the odds YOUR hedge fund manager will do that? Very small odds indeed. Why bother?  Just buy the index fund right?

To look at it another way, a hedge fund manager needs to outperform a stock market index fund by 4% just to allow you to break even with an index fund!  He or she would need to be a genius of alien proportions in order to be able to average 4% over an index fund over say 20 years!  I'm sorry, that is just not going to happen very often - if ever.  Think about it.  To beat an index fund that is expected to return 8% by 4% what we are really saying is the manager needs to beat the market by 50% (4/8=0.5)!

But wait!  It gets even worse!  Many individual investors (and even some sizable pension funds and endowment funds) invest in hedge funds through what is called a "fund of funds."  Perhaps you or an investment advisor don't think they can pick the right hedge funds.  A simple thing to do is to invest in a fund that will invest your money in hedge funds for you.  These "funds of funds" are popular.  But when you see "fund of funds" you should think "FEES on FEES!"  Shall we run the numbers?  Get your pencil or calculator ready - we are about to do some more addition and subtraction using percentages!

So, what does the typical fund of fund manager charge?  You probably guessed "2 and 20" and you'd be right in some cases.  But, even if you find a fund of funds that charges "1 and 10" your odds of beating simple index funds is nearly zero.

Unfortunately, our stock and bond markets are pretty darn efficient.  Any news about a company gets priced into their stock or bond prices almost instantly.  There just is not enough inefficiencies available for a hedge fund to charge 4% in annual fees and still pass through a net return that beats an index fund.  So, just buy an index fund! And, if you are worried about stocks and want to "hedge" your bets, buy an index bond fund, too.  Bonds usually go up when stocks go down.  That's all you need to know and you'll likely beat the pants off all the super expensive hedge fund managers and all their fancy Ph.D's.

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