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Hedge Funds have been a hot investment
lately. Once reserved for the very wealthy, hedge funds now have
minimum investments as small as $10,000. Should you jump onboard the
hedge fund bandwagon, or let this latest investment craze pass you
by?
Hedge funds are pools of private money that use specialized
investment strategies in an attempt to earn greater returns for
their investors. They can invest in just about anything in an
attempt to make money. Usually, hedge fund strategies include the
ability to short the market so they can profit by correctly timing
market declines.
Hedge funds have become popular because, historically, some have
returned over 20% per year. As a result, the number of hedge funds
has grown dramatically the last few years. Many successful mutual
fund managers have left fund companies and started their own hedge
funds. Since hedge fund managers often receive as much as 20% of the
gains, the managers can make a lot more money.
Hedge funds are normally structured as a partnership or a limited
liability company. As such, only ‘accredited’ investors can
participate. An accredited investor is someone with over $1,000,000
in investable assets or an annual income over $200,000 per year.
Not a lot of people fall into this category. And Wall Street knew
those high returns would be an easy sell to other investors. So they
created a fund of hedge funds. Think of it as a mutual fund that
invests in hedge funds. Voila, small investors now have access.
Don’t let the attraction of high returns tempt you into investing in
a hedge fund or a fund of hedge funds. I believe they are unsuitable
for almost every investor. Here’s why.
First, those sky-high returns were achieved when there were a small
number of hedge funds pursuing each strategy. Now there are so many
hedge funds pursuing similar strategies, the returns aren’t there.
Worse, it’s forcing managers to pursue even riskier strategies.
It’s like being at an auction. If you are the only one bidding
you’ll probably get a great deal. If you are one of a hundred
different bidders there’s not much chance of getting a bargain. In
fact, if you don’t watch out you might even pay more than the item
is worth. That’s what has happened in the hedge fund world.
Very few hedge funds have current returns anywhere near those
stellar returns of the past. In fact, it’s been reported that the
majority of hedge funds have actually performed worse than the
market indexes for much of this year. Some have even closed down and
returned the money to their investors because they couldn’t meet
their objective.
Hedge funds have very high costs. Whereas an expensive mutual fund
might charge a 1.5% management fee per year, the typical hedge fund
charges 2%. Plus, the hedge fund manager will typically take 20% of
any gains. It’s even worse with a fund of hedge funds because there
is an additional layer of fees. You take the risk, they take the
reward.
Hedge funds and funds of hedge funds have little regulation and even
less disclosure. The potential for fraud is high and transparency is
low. Investors are trusting someone they don’t know to handle their
money and will have little idea what they are doing with it. Big
money investors get info the small investor can’t.
Most hedge funds require that you remain invested for a set period
of time—say 1 year. If investors start withdrawing their money, it
may force the manager to sell investments at a loss, harming the
investors that remain.
Since hedge funds with long histories of stellar returns are closed
to new investors, you’ll have to take a chance on managers with
little or no experience in the Wild West world of hedge fund
investing.
Lastly, for those who must have alternative strategies, there are
many options to short the market or to get double the market return
through mutual funds offered by Rydex and Profunds. These mutual
funds are transparent, regulated and much, much less expensive. Even
so, they still aren’t for the faint of heart!
So I recommend investors let the hedge fund bandwagon pass them by.
Have a financial question? Send me an email and I’ll personally
respond, free of charge. Go to www.guardingyourwealth.com and click
on ‘Ask Jeff’.
In addition to being a nationally syndicated columnist and Certified
Financial Planning Practitioner, Mr. Voudrie provides personal,
private money management services to clients nationwide. |
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