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Like mutual funds, hedge funds are pools of underlying securities, but with noticeable differences. Hedge funds are not regulated by the Securities and Exchange Commission the way mutual funds are. As a result of being relatively unregulated, hedge funds can invest in a wider range of vehicles than mutual funds. While traditional funds generally stick to stocks, bonds and cash (sometimes commodities and real estate), hedge funds often stray to more complex and risky investments, including futures, options and currencies. Certain hedge funds also attempt to hedge against declines by investing in stocks and later shorting them. And many hedge funds employ leverage by investing with borrowed money, which increases the risk.
Hedge funds are complex and risky, and the added complexity and risk has not resulted in better outcomes. In fact, hedge fund outcomes have been much worse than traditional funds.
Hedge Funds Underperform
A recent article in The Wall Street Journal displays the recent results of 18 different hedge fund strategies and the Barclay hedge fund index. None of the hedge fund strategies or the hedge fund index exceeded the 13.42% return of the S&P 500 total return over the last five years. None even came close, except the “collateralized debt obligations strategy,” which earned 11.07%. Most of the strategies earned 2% to 5%.
Andrew Hallman, the author of The Millionaire Teacher, wrote a blog post covering a much longer time horizon. Andrew compared the performance of the surviving hedge funds to a portfolio made up of global stocks and U.S. bonds, starting the comparison in 2002 and ending in 2016. If $10,000 were invested in the average surviving hedge fund, it would have grown to $12,330, while a portfolio containing a global stock index (70%) and a U.S. bond index (30%) would have turned that same $10,000 into $27,116.
Going even further back, let's compare the performance of a basic 60/40 “kindergarten portfolio” (60% Vanguard Total Stock/40% Vanguard Total Bond) with the HFRX Index, which is designed to be representative of the overall composition of the hedge fund universe. Below is a comparison of the two strategies over the last 20 years.
Finally, an article from The Atlantic explains hedge fund underperformance with concision: "There are some ideas worse than putting your money in a hedge fund – like burning it – but not many. Indeed, the supposedly smart money has not been so for the past decade, at least not for actual investors. Hedge funds have cumulatively underperformed a simple 60-40 stock-bond index going back to 2003 – and underperformed it badly."
Examples of Unsuccessful Investments
Here are specific examples of some hedge fund professionals that had many investors believing they were elevated:
Bill Ackerman was a silver-haired “hedge fund titan” who built his reputation as a stock picker and hardball activist. His approach was to buy up shares in the business and shake up management, hoping to raise the stock price. For a while it worked, as he generated good returns and astronomical fees for himself and his firm, Pershing Square. But then he made the biggest bet of his career in a pharmaceutical company, Valeant. When skeptics began dumping Valeant, he bought more. Valeant dropped from $200 a share to as low as $8.00. By the time Ackerman threw in the towel and sold his firm’s shares in the company, the fund lost $4 billion.
Richard Perry has long been long considered one of the hedge fund industries most successful investors. Who would dare question a Wharton graduate with an MBA from NYU, who started his career at Goldman Sachs and is the nephew of former Bear Stearns CEO James Cayne? Many did not until he shut the doors to his hedge fund Perry Capital in 2015 after billions of dollars in losses. Perry's fund lost 60% from 2014 to 2016. In his letter to his former believers, he wrote about “the timing for success in our positions too unpredictable” – a glimpse into the obvious.
John Paulson is known as one of the most prominent names in high finance and was a billionaire philanthropist from Harvard. The Paulson Partners enhanced fund crashed about 70% from 2014 to 2017, partly because it used leverage (borrowed money) to double down on its bad bets.
Hedge Fund Benefits
Notwithstanding all of this bad news, hedge funds may serve some very important functions within our society. Many experts believe their trades can bully mispriced securities back in line with reasonable valuations. And there is no question that because hedge funds trade so often, and in such exotic fashion, that they provide needed liquidity to the system.
Further, it is likely that hedge funds improve the overall quality of the capital markets and may even influence the culture of a company positively with their clout. The following excerpt is from “The Economics and Finance of Hedge Funds," posted on the Harvard Law School Forum on Corporate Governance and Financial Regulation: "Critics of hedge funds often label hedge funds as greedy corrupt and highly compensated villains... proponents of hedge funds view them as informed traders who improve market quality and corporate governance."
The Solution
Despite all the outlined problems with hedge funds, they have been growing at an astonishing pace. According to Seeking Alpha, in 2003 there were 5,065 hedge funds with $218 billion in assets. As of Q3 2017, there were 8,255 hedge funds with $4.470 trillion in assets. Whether that growth continues is anybody's guess, but it appears hedge funds are here to stay. The solution is to utilize hedge funds appropriately.
Are you an institutional investor or pension fund or manager? Do you manage a sovereign wealth fund on behalf of an entire country? If so, perhaps you should consider investing in a hedge fund. If you are ultra-affluent ($50,000,000 or $100,000,000 of investable assets) and fully understand leverage, options, futures and derivatives and want to try to boost returns, maybe a hedge fund makes sense. But for the rest of us, we should avoid the fees, complexity and risks associated with hedge funds.
Read more: Hedge Funds: Not for the Ordinary Investor | Investopedia https://www.investopedia.com/advisor-network/articles/hedge-funds-not-ordinary-investor/#ixzz5WHQnKaDW
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