Are Hedge Funds Too Hot for Investors?

When everyone starts referring to aninvestment as hot, it's time to watch out.Hedge funds have now achieved thatdubious status. Likely, not many physician-investors are seriously considering investing inthem, which is good. But as the stock market meandersand the fixed-income market continues to offer onlypuny returns, more and more investors, especiallyretirees, are growing impatient or panicking. Theseinvestors are ripe for picking by hedge fund sales people.

Remember:

Institutional investors have already begun falling forthe hedge fund story just as they fell for the tech stockstory because they are also panicking. Returns in the stock market or any market don't comeuniformly over time. If you can resist jumping into anymarket that is too hot, your patience will pay off.

Making Past Projections

Citigroup recently published a study of hedge fundperformance covering the period since 1990. Over thisperiod, hedge funds provided an average annual returnof 11.9%, compared with 10.5% for the S&P 500 and9.2% for the average mutual fund. If you have ever satthrough a pitch on hedge funds, those numbers shouldsurprise you. Considering their higher risk, you probablyexpected hedge funds to outperform the stock market by10% or more per year.

Consider:

But averages are often misleading. WhenBill Staton walks into a room, the average wealth of thepeople in the room goes up by tens or even hundreds ofmillions of dollars, but no one actually gets any richer.

For hedge funds, the average hides the fact that theirreturns were higher in the earlier years and have beendeclining recently. They are expected to remain low inthe future, partly because the number of hedge funds isexploding and all of the very smart managers are competingfor the same limited opportunities.

One big strike against hedge funds is their exorbitantfees. Hedge fund managers have nicely set themselves upfor a game of "heads I win, tails you lose."They takehigh—and often enormous—risks with your money. Ifthey make money, they pocket a good share (ie, 20% to25%) of the profits. If they lose money, the loss is allyours. And that's not all. In addition to the share of profits,you pay 1% to 2% of assets in annual fees, irrespectiveof how the fund does.

But those were the good old days. More recentinformation shows that some funds that have done wellrecently have increased their annual fees to 3% or moreand their cut of profit to 30% or more. In the long run,the reversion to the mean law (ie, a fancy way of sayingwhat goes up must come down) is almost asdependable as Murphy's Law.

Lesson:

You may remember the story of Long-Term CapitalManagement (LTCM), a hedge fund run by two NobelLaureates in economics along with a group of very smartWall Street professionals. LTCM did spectacularly wellfor several years before it crashed hard and went out ofbusiness. It ended up producing spectacular losses for itsinvestors and sent shockwaves through the world'sfinancial markets. The Federal Reserve Bank had to stepin to manage the damages. Past performance isof limited value for projecting future returns.

Zero-sum Fund Game

A zero-sum game is another fancy term used byeconomists to refer to situations in which one party cangain only what another party loses. Most of the investmentsthat hedge funds make are zero-sum games. Foryour hedge fund manager to make money, other hedgefund managers have to lose a similar amount. Given thatmost hedge fund managers are very intelligent, there islittle chance that a select few of them will be able to keepwinning consistently at the cost of the others for long. Itis more likely that some of them will win for a period bychance, and then the crown will pass to another group.So if you want to make money by investing in hedgefunds, you will have to be very smart or very lucky tokeep picking the winners.

In theory, hedge funds have many advantages overstocks and bonds. In practice, your chances of comingahead by investing in hedge funds are very small. Youmay only succeed in enriching the fund managers.

author of The Only Proven

Road to Investment Success (John Wiley; 2001)

and Financial Modeling Using Excel and VBA

(John Wiley; 2004), currently teaches finance at

the Fordham University Graduate School of

Business and consults with individuals on financial

planning and investment management. He welcomes

questions or comments at chandansen@aol.com.

Chandan Sengupta,