Real life doesn’t always live up to our expectations.
It might be the “dream job” that comes with unforeseen nightmares, or the fabulous vacation spot that leaves some visitors surprisingly nonplussed, or the big lifetime celebration – such as a wedding – that is remembered more for big bills or family fights than for the love and joy of the moment.
In investing, the security atop many wish lists is a hedge fund, a private investment pool that is the domain of big institutions and people the financial- planning community describes as “high-net-worth investors.”
For everyone who aspires to be a high-net-worth investor – and who doesn’t? – hedge funds are sometimes seen as a sign that you have “made it.”
But hedge funds may be another case in which true life doesn’t always live up to the hype, and a new study out from a San Francisco wealth management firm suggests that most hedge-fund investors aren’t actually getting a performance boost by going the exclusive route. Investors may dream of buying a hedge fund run by a legend such as George Soros, but they are much more likely to get something far more pedestrian and disappointing.
For fund investors, the lesson is that you’re probably better off managing your money conventionally than pining – or paying an adviser – to overhaul your portfolio to “invest the way the rich do.”
To see why that is, let’s consider how hedge funds work and then maybe why they don’t always work for individual investors.
Hedge funds are unregulated investment vehicles. Like ordinary mutual funds, they can have an investment objective and style, but unlike most open- end funds, they can also take complex investment strategies designed to profit in all market conditions. Hedge funds are available only to qualified investors, effectively people or institutions with a large chunk of money they can pour into a fund whose holdings they will know very little about. That small group of investors can’t get its money back on a whim – withdrawals are allowed only at certain intervals, and the window is small – but it can decide to close down a fund if it doesn’t believe management is doing well.
Management, meanwhile, typically gets paid a flat fee of 1 percent, plus 20 percent of any profits. That kind of payday attracts a lot of money managers, but not all of them are good. Those costs kill investors in mediocre hedge funds.
“It’s not that hedge funds are bad,” says Jeff Spears, managing director of Presidio Wealth Management in San Francisco. “It’s that most don’t measure up, and the person getting into hedge funds for the first time isn’t going to get into the few funds that really have proven that they can get the job done.”
Presidio recently completed a research report that compared the performance of a diversified investment portfolio to the Hedge Fund Research Fund of Funds Composite Index, the industry benchmark for hedge funds-of- funds. Typically, individual investors use a fund-of-funds when they first go into hedge funds, because it diversifies the risks.
From April 2000 – the height of the bull market – through March 2006, Presidio found that the diversified portfolio (40 percent taxable bonds, 20 percent large-cap domestic stocks, 10 percent high-yield bonds, 15 percent international equity, 10 percent domestic small-cap stocks and 5 percent emerging markets) generated an average annualized return of 6.2 percent. The hedge-fund index gained 5.2 percent.
Billions of dollars poured into hedge funds during that period, in large measure because investment advisers felt hedge funds would give superior bear- market results.
Hedge funds lagged not only during the down period, but over the longer haul as well. Since 1990, when the hedge-fund index was started, the diversified portfolio delivered 10.6 percent annually, compared with 10.1 percent for the hedge funds, Presidio showed.
“Hedge-fund managers talk about the benefits of lower volatility, better diversification and superior performance a hedge fund gives your overall portfolio, but that’s not what most hedge funds are delivering,” says Spears. “But you can get all of those things – plus full transparency and everyday liquidity – just by sticking with regular mutual funds.”
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.
