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Dan Solin Headshot

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

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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.

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