“Secretariat couldn’t win the Kentucky Derby with Shaquille O’Neal on his back.”
That’s how John West, a managing director at Research Affiliates in Newport Beach, Calif., summarizes the problem with hedge funds. You can have the fastest horse on earth, but it won’t do well if you make it carry a heavier rider than all the other horses. That, of course, is exactly what hedge funds do with their heavy, off-the-scale management fees.
In case you aren’t familiar with these intensely managed investment vehicles, a typical hedge fund charges 2 percent in management fees and 20 percent of any profits. More fees are added for creating multiple-manager “fund of funds” hedge funds.
What I call the basic “Couch Potato” portfolio had a humbling year for 2013 — but it still trounced the Bloomberg Hedge Funds Aggregate Index. The 2,257 funds in that index returned an average of 7.4 percent for the year, while a simple and inexpensive portfolio of two index funds mixed 50/50 returned a modest 10.41 percent at materially lower risk. Hedge funds also trailed the stellar 32.39 gain of the S&P 500 index.
So much for the so-called “smart money.” Fortunately, you can’t be just anyone and invest in a hedge fund. You must be an “accredited investor,” a term of art that means you’ve got a personal income of at least $200,000 a year, a household income of at least $300,000, or a household net worth of at least $1 million.
The requirement is supposed to keep the common folk out of the game and protect them from harm. But it also creates a great opportunity to use the investment as a way of letting other people know you’re pretty well off, a bit like mentioning the terrible shortage of reliable gardeners in Palm Beach or how much you enjoy the opera season in Santa Fe. Functionally, hedge funds make better status symbols than investments.
As a practical matter, hedge funds serve the same purpose for the well-off as lottery tickets serve for the common man: Both are tools for the efficient redistribution of money. For hedge funds, the redistribution goes from the proud client to the still prouder fund manager. For lottery tickets, the redistribution goes from the witless to (insert name of state here). The difference is that while lotteries have been characterized as “a tax on people with low IQs,” few question the intelligence of hedge fund investors.
The evidence suggests that such questions are overdue.
Let’s start with the big picture. According to Simon Lack, the author of The Hedge Fund Mirage (Wiley & Sons, 2012) and a former scout for hedge funds who knows the business inside and out, “If all the money that’s ever been invested in hedge funds had been put in Treasury bills, the results would have been twice as good.”
In other words, net/net, investors get all the risk but none of the expected return for that risk because, well, the return goes to the managers in fees.
West takes a more subtle view. He asks whether hedge funds actually hedge (or reduce) risks or increase returns to fund tasks, such as retirement. To measure that, he compares what happens when you add different amounts of the hedge fund average to a standard 60/40 portfolio to doing the same thing with an unmanaged, equal-weighted portfolio of 16 asset classes. If hedge funds are working, returns will be increased with little additional risk.
For the longest time period he measured (March 1997 to December 2013), adding a 33 percent exposure to hedge funds would have reduced the return of the standard portfolio by an annualized 0.6 percent, with a modest reduction in risk. Adding a very Couch Potato Building Block Portfolio-like equal-weighted portfolio of 16 asset classes, however, did more. It would have increased returns by 0.2 percent annualized while also providing a small reduction in risk.
Shakespearean terms like “much ado about nothing” come to mind about this $2.25 trillion investor shakedown, but the “Where’s the beef” commercials from 30 years ago are more to the point for investors. Hedge funds are big on bun, short on beef.
Questions about personal finance and investments may be sent by email to scott scottburns.com.