Hedge Funds Are An Expensive Way To Lose Money

A recent article by Stephen Taub (�More than 80% of Hedge Funds Underwater�, Institutional Investor, October 21, 2011) found that 80% of hedge funds lost money on a year-to-date basis, as of September 30.  I think hedge funds play a diversifying role in most client portfolios, but they are certainly not a panacea.

The illusion of hedge fund invincibility was shattered in 2008 when the average hedge fund lost 19.1%, according to the Dow Jones Credit Suisse Hedge Fund Index.

In recent times, the term �hedge fund� merely refers to an investment within a partnership structure with the ability to charge incentive fees.  In fact, many hedge funds do not hedge at all, but rather speculate.  This fact is not a surprise to anyone who closely analyzes hedge funds.  However, it was clearly a shock to the typical individual investor with hedge fund investments during the Great Recession.  The fact that many hedge funds are down year to date further takes the luster off this once vaunted asset class.

In my view, the lack of hedge used by many hedge funds is the least of their problems.  A more than cursory analysis of a hedge fund will reveal their true downside exposure.  Unfortunately, most hedge funds do not offer investors the transparency to perform this analysis.

Perhaps their biggest problem, which hasn�t received as much attention, is that hedge funds must put up huge gross returns in order to deliver merely �adequate� net returns to the client.

The majority of individual investors typically invest in hedge funds through a fund of fund vehicle to achieve �instant diversification,� for investments usually under the $1 million minimum required for many direct hedge fund investments.

My example focuses on an investment in a hypothetical fund of funds.  To be conservative, I assumed that the individual hedge funds that comprise the fund of funds charge fees of 1.5% of assets and 20% of profits.  In fact, many hedge funds charge 2% of assets, as well as 20% of profits.

�Star� funds, such as those operated by Renaissance Technologies and SAC Capital, charge much higher profit-sharing fees, with some as high as 50%.  My example also assumes an annual expense ratio of 0.65% for both the individual hedge funds and fund of funds.  Lastly, I assume the fund of funds charges industry �standard� fees of 1% of assets and 10% of profits.

The net results to the investor are startling.  A 15% gross return shrinks to a 7.8% return for investors, after paying the various fees and expenses along the way.    Although I do believe there is a small subset of talented hedge fund managers out there, consistently delivering a gross return of 15% is a tall task � particularly in today�s markets and especially for funds with a true hedge.