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Why Hedge Funds Do Not Belong in Your Portfolio

Hedge funds are often peddled as a unique asset class that has outstanding returns that are uncorrelated with the market, therefore they are a good inclusion in a portfolio. In reality, hedge funds are as much an asset class as Las Vegas is.

Hedge funds are private investment companies that are organized as limited partnerships with fund managers as the general partners and investors as limited partners. The keyword here is private. By law they are not supposed to be sold to the public; thereby, they are exempted from SEC oversight. But sold to the public they are! It is not the first time unscrupulous “financial advisors” have pushed the limit of the law, while the SEC looks the other way. (For related reading, see: The Hidden Cost of Hedge Funds.)

And hedge funds have exorbitantly high fees. The typical fee structure is 2/20, that is a 2% management fee and a 20% performance fee. To be worthy of the fees, the fund manager has to perform like Michael Jordan on the basketball court. The problem is: there are few Michael Jordans in the hedge fund world, but there are many pretenders who charge like him.

In 2005, Princeton economics professor Burton Malkiel published a study titled “Hedge Funds: Risk and Return.” After examining hedge funds in-depth, he concluded:

"Hedge funds are riskier and provide lower returns than commonly supposed."

Then there is a new book about the hedge fund industry by former insider Simon Lack. Its title says it all: “The Hedge Fund Mirage – The Lesson of Big Money and Why It’s Too Good To Be True.” Let me borrow the line from the book and please read carefully.

"Between 1998 and 2010, hedge fund fees totaled $440 billion versus $9 billion total profits for investors!"

This result does not even take into account survivorship and reporting biases. Since hedge funds are not under SEC oversight, their performance data are gathered by a number of commercial companies and the reporting is entirely voluntary and unverified.

Hedge funds that do well have a much higher incentive to report their results than hedge funds that don’t do well. This is the so called reporting bias. And hedge funds that do so badly that they have to close up shop don’t report at all. This is the survivorship bias. By the author’s estimate, if these biases are accounted for, investors actually lost $308 billion in hedge fund investments.

These results should not be surprising at all. Would you go into a business whereby the manager claims to have a secret way to make money but he can not tell you how, he keeps the book and the profits, and you take the entire losses? Common sense says no. Yet when the business is a hedge fund, many investors throw their common sense out the window.

Simon Lack’s book should be a wake up call. By all accounts, hedge funds (as well as funds of funds) are a giant wealth transfer scheme to move money from investors to hedge fund managers. That’s also why David Swensen, chief investment officer of Yale Endowment, called them the cancer of the financial world.

Trust me, you don’t want to have cancer in your portfolio. (For more, see: How Understanding Risk is Key to Investing.)