It's Easy to Invest $2.02 Trillion the Wrong Way

Just buy hedge funds. That's how a record $2.02 trillion is currently invested. Nothing better represents the continuing transfer of wealth from those who make money to those who manage it than this staggering investment in an industry that has demonstrated no ability to achieve better than index based returns for a given level of risk.

It's an oxymoron to call investors in these funds "sophisticated", even though they are legally required to be in order to make these investments and for the privilege of paying an average of 2% of assets plus 20% of profits to underperform the markets.

In a recent blog, Jay D. Franklin summarized the risks and lack of understanding of hedge fund investments as follows:

1. High returns means high risk. While this is true of all investments, it is especially so with hedge funds which can be highly leveraged. It's not infrequent for funds to have stellar returns in one year, followed by devastating losses the next;

2. Poor returns. Studies have shown that, on a risk adjusted basis, hedge funds, on average, fail to provide a higher return than a simple S&P 500 index fund. This is not surprising given the ridiculous fee structure of these funds. David Swensen, author of Unconventional Success: A Fundamental Approach to Personal Investment, stated that "[I]nvestors in hedge funds find generating risk-adjusted excess returns nearly an impossible task." The index fund has other advantages. An investment in an index fund is liquid. Investments in hedge funds often are not, requiring lengthy waiting periods before you can get your money out.

The pressure to live up to the hype has caused some hedge fund managers to resort to insider trading, as I discussed in my blog last week.

Others have thrown in the towel and closed. According to a web site that tracks hedge fund implosions, 117 major funds at 71 fund families have shut down since 2006.

Think about it this way: Is it logical to assume there is a group of super human managers who can outwit the billions of traders looking at all the publicly available information about every listed stock and embed that information into the price of those stocks? Can these managers foresee tomorrow's news which is what actually affects stock prices? If they had the magic formula, wouldn't one of the many academics who study the capital markets have published their methodology in a peer reviewed financial journal?

The reality is, as Ben Stein correctly noted, that hedge funds "are not necessarily a great investment, but they are a great compensation program for hedge fund managers."

The hedge fund phenomenon is simply an extension of the broker shell game. Both promise better than market returns. Neither can deliver. Both earn billions of dollars of fees for a purported expertise they don't have and which doesn't even exist.

Hapless investors continue to suffer, as retirement for them becomes a distant memory.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

 

 

 

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Comments

[SeanN]

12:45 AM on 04/30/2011

Dan Solin is a voice of reason in the wilderness.

[Steven Weydert]

10:09 PM on 04/27/2011

It certainly is odd that many people remain uneducated about the information presented in this article. Hedge fund managers exploit this lack of education on a grand scale. Proper exposure to investment risk and an awareness of the particular dimensions of risk that drive returns is what matters. A mountain of academic evidence from across the decades overwhelmingly demonstrates that, after adjusting for risk, managers add zero value picking securities - especially after fees. That's because the market represents the aggregate of information and opinion - millions of pieces of information and millions of opinions - and no individual can reliably assess and exploit the immeasurably complex interworkings of market participants. If they could, there would be some peer-reviewed academic evidence of it. But there isn't. To the extent capitalism is believed to work, a good manager simply ensures folks remain exposed to the proper level of risk (and the right kinds of risk) for their situation as cheaply as reasonably possible. That's where advisors add value.

[blueken]

03:49 PM on 04/27/2011

Hedge fund managers use a mathamatical formula devised by John Nash to predict point in a chaotic system. John Nash won a Nobel prize, and was certifiably insane. Even Nash said that his formula would work until one more variable was entered. Then it wouldn't and you should stop useing it until equalibrium was restored to the chaotic system. That is to say the normal and usual amount of chaos. The problem is that when you are highly leveraged it is hard to stop. The interest payments continue and the shareholders demand return. That's how most hedge funds collapse. They just can't stop.

[Robert Cantor]

03:08 PM on 04/27/2011

Too Long Too Low Fed interest rates have created this phenomenon.

[FoxIslander]

02:30 PM on 04/27/2011

"The hedge fund phenomenon is simply an extension of the broker shell game. Both promise better than market returns. Neither can deliver. Both earn billions of dollars of fees for a purported expertise they don't have and which doesn't even exist. "

...pretty much sums it up for me.

[GarryK]

09:33 AM on 04/27/2011

"The hedge fund phenomenon is simply an extension of the broker shell game. Both promise better than market returns. Neither can deliver. Both earn billions of dollars of fees for a purported expertise they don't have and which doesn't even exist."

Another of your outstanding honest, important, and easy to understand columns, Mr. Solin.

Thanks, and please keep delivering this message.