Are Hedge Funds a Good Gamble for You?

With the stock market's doldrums, someonemay have already suggested hedgefunds as an attractive alternative to you.In the past few years, many institutionalinvestors, such as pension funds and endowments, havebeen putting some of their money into hedge funds.Should you answer this siren song?

Bet on Fund Managers

Although hedge funds are very different from mutualfunds, it's helpful to try to understand them by lookingat some of the key differences. Most mutual fundscan only hold long positions in stocks and bonds, whereashedge funds can hold both long and short positions instocks, bonds, and many other commodities and financialinstruments (eg, crude oil and currency futures).Short positions make money when prices go down andlose money when prices go up.

Key advantage:

Because they're limited to long positions, mutualfunds can make money only when stocks go up, generallydon't make money when stocks move sideways, andlose money when stocks go down. Hedge funds that are designed to go both long and shortin stocks can make money, at least in theory, whether thestock market goes up or down. Other types of hedgefunds that invest in currencies (eg, euro) and commoditiescan make money depending on the price movementsin those markets, and, therefore, provide positive returnsirrespective of the stock market's direction.

Most hedge funds are highly leveraged, which significantlyamplifies profits when the fund manageris right. Unfortunately, it also significantlyamplifies losses when the manager iswrong. This makes hedge funds highlyvolatile and risky.

The problem:

Whether a hedge fund makesmoney or not almost entirely dependson the skills of its managers. To make money consistently in ahedge fund, its manager must be agenius, but geniuses are rare in anyfield. While highly successful hedge fundmanagers like George Soros are hailed asgeniuses, it is uncertain whether they can beidentified ahead of time. In fact, most hedgefunds end up losing a lot of money.

Lay out Steep Fees

Another problem is the outrageous fees andcosts of hedge funds. Hedge funds generally chargeinvestors an annual fee of 1% to 2% of assets, plus aperformance fee of 20% or 25% of profits—on top ofthe fund's fairly high transaction costs. Let's assume youinvest $100,000 in a hedge fund and at the end of thefirst year the value of your share goes up to $120,000.The performance fee rate of 25% will apply to the profitof $20,000, and $5000 of fees will be deducted fromyour account. The $120,000 now becomes what isknown as a high-water mark, which means you won'tbe charged any additional fees until the value of yourshares exceeds that amount. But you willnever get back that $5000, no matter howpoorly the fund does in the future.

Performance fees based on the highwatermark create a perverse incentivefor the fund manager. Assume thatthe fund later performs poorly andthe value of your shares falls to$80,000. Since the manager is notgoing to earn any more performancefees until the value of yourshares goes back above $120,000,they will have incentive to take outrageousrisks, which can lead to catastrophiclosses.

In the hedge fund world, this happensoften. Many hedge funds flame outin this way, the fund is closed, and anyremainder is distributed to investors.The investors suffer huge losses and the managers oftengo on to start new funds. I suggest avoiding hedge fundsentirely, or at least allocating a very small proportion ofyour portfolio to these risky investments.

Chandan Sengupta, 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.