Hedge Funds & A Better Alternative

by Wes Bridel on March 21, 2011

in Stewardship

Hedge Funds are sexy!  Why?  Because that’s how rich people invest!  Well, Ok, but that might not be such a good thing.  Let’s break down what a hedge fund is and we’ll see that there are some advantages and disadvantages to them.  We’re continuing the series on money management and funds.

A Hedge Fund is an investment fund which is less regulated and more able to utilize alternative investing techniques than other funds.  Investors must be accredited (Assets over $1M or consistent income and assets over $200,000/yr) to participate.  The idea behind them is that they hedge risk with sophisticated techniques.  In reality, like any other fund, most are terrible and some have fantastic years.  Overall, they seem to average 5 or 6% per year and are non correlated to the overall market because of the variety of techniques employed.

Of course, each fund is individual and has its own strategy and manager.  One of the best things about hedge funds is that many of the brightest investors on the planet gravitate to managing a hedge fund.  Thus, you are able to have one of the smartest investors in the world managing your money.  And sometimes, they hit home runs and have amazing returns.

The biggest downside is that they typically have massive fees.  It’s common to have a fee structure of “2 and 20”.  This implies a management fee of 2% and a performance fee of 20% of the growth.  (Some hedge funds have much higher fees.)  Some funds use high water marks so that if the portfolio goes backward, you do not have to pay a huge performance fee to get back to where you started.  Other funds have hurdle rates that must be earned before performance fees kick in.

These fees might not seem so bad if you’re chasing return by putting your money with a manager who had a fantastic year the year before and earned 120% in her portfolio.  What’s not to like about earning a net 98% for a year? However, you have to realize that it’s unlikely she’ll duplicate this feat.

Imagine you were a close friend of the Buffett family when Warren got started investing money and decided to invest.  You would be incredibly wealthy today because you just happened to hitch your wagon to one of the world’s greatest investors over the decades when he was producing the great incredible gains.  However, if he had run his company as a hedge fund, the 20% performance fees which are common today would have eaten up the vast majority of the wealth that was built.  Even though you were along for the ride with one of the greatest investors of all time, you would not be wealthy today with this performance minus the typical fees of a hedge fund.

Nothing is all good or all bad, so there might be a perfect opportunity for you in the world of hedge funds, but keep in mind the damage huge fees can do to long term returns as your analyzing the opportunity.

One option that has recently come available is ETF’s that focus on certain hedge fund strategies.  These funds are not the type of hedge fund that will make an enormous amount of money in a single year, but instead employ strategies that are non-correlated to the market as a whole.  This can add important diversification to your portfolio.

This is Part 6 in a series on professional money management and funds.  You can find the prior posts by following these links: Pt 1, Pt 2., Pt 3, & Pt 4, & Pt 5.

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