05/27/2008 09:39 pm ET Updated May 25, 2011

Smart Advice for the HuffPost Investor: A Hot Tip On Hedge Funds!

Question: What's going on with hedge funds these days?

Answer: There are over 8000 hedge funds. Wealthy investors have poured over $1 trillion into them. Stories of outsized returns fill the financial media.

The hard data tells a much different story.

Exhaustive studies of the performance of hedge funds have found that investors could generate the same or better returns by investing in an S&P 500 index fund. One study of 1917 funds found that only 17.7% beat this benchmark.

The promise of huge returns drives investment in these funds. The possibility of disastrous losses is rarely discussed. The foundation of all returns is risk. Hedge funds that deliver big returns are taking big risks. The markets are not a one-way street.

The SEC is quick to take action when funds engage in illegal activity, but what is it doing to protect investors in these funds? Nothing. Currently, hedge funds are not even required to register with the SEC.

Recently, the founder and chief executive of the International Management Associates hedge funds was found guilty of money laundering and fraud. The collapse of these funds costs investors, including some well-known NFL players, more than $150 million.

A number of other hedge funds have imploded. You will recognize the names of some of the investment banking firms that ran them: Bear Stearns, Dillon Reed, PNP Paribas and Russell Investments. Fraud was not an issue with these funds. They just lost billions of dollars (in the aggregate) of investors' money and closed down or restructured. Others are sure to follow.

Presumably, these funds were run by some of the best and brightest that Wall Street could recruit.

Here's my "hot tip": Just say "no."

Question: Do you "cherry pick" your numbers to bolster your arguments for passive management?

Answer: Active managers need to "cherry pick" their numbers to justify their existence. Passive managers rely on exhaustively documented, long term data.

When the financial media reports on the performance of actively managed funds, they do not take into consideration the returns of those funds that went out of business due to poor performance. The next time you see a report on the "average performance" of actively managed funds, you should be aware that this data omits the poor performance of up to 35% of the total number of these funds that are no longer around.

Studies of actively managed funds reveal the following:

- Over a long term period (10 years or more) less than 5% of active managers will equal or exceed their benchmark.

- Superior active fund managers are unlikely to repeat their performance in subsequent periods;

- A ten year study of the performance of the endowment funds of over 2500 colleges and universities showed a consistent pattern of under performance, when measured against a comparable portfolio of funds passively managed by Dimensional Fund Advisors.

- The average investor in an actively managed fund significantly underperforms both the returns of that fund (because investors jump in and out of funds, usually at the wrong time) and the relevant benchmark.

If investors believe they can beat these odds, they are certainly free to pick actively managed funds or portfolios of stocks.

However, they should be aware that they are gambling and not investing.

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.