National Post (National Edition)
Hedge funds not all they’re touted to be
Iam old enough to remember when hedge funds were ‘cool’. They were part of an exclusive club: hard to get into, great returns, low risk. Investors would talk about their hedge funds and investment at parties, with others hoping to get an introduction to the fund so they could get great investment returns too.
This all ended, of course, with Bernie Madoff’s huge hedge fund scam. But even before this, I always wondered what the big attraction was with hedge funds. Nowadays, pretty much anyone can start a hedge fund, and rules have changed so that it is easier than ever to buy them. But why would you even want to? Let’s look at five reasons why hedge funds might not be the great investments you think they are:
THE FEE STRUCTURE IS HORRIBLE
In these days of ETFs with 0.05 per cent management fees, the fact that most hedge funds charge 2 per cent plus 20 per cent of performance is, simply, ridiculous. Why ‘sophisticated’ investors would pay these fees is beyond me. There is nothing inherent about hedge funds (except perhaps a better ability to do short selling, and the fact that money can be ‘locked in’ for a period of time) that makes their likelihood of investment success any better than a mutual fund, and we all know how mutual funds do (95 per cent of managers cannot beat the benchmark). Sure, hedge funds as a group can show a good investment year, on occasion. Individual funds, at times, can have spectacular years. But the high fee drag and efficiencies of markets mean most hedge funds will simply gravitate to average investment performance, at best, over time.
PERFORMANCE FEES ARE ONE-WAY
Suppose a hedge fund has a great year and returns 40 per cent, pre-fees. With the 2 per cent management fee and 8 per cent performance fee, you’ll get to keep 30 per cent. A $100,000 investment becomes $130,000. Not too shabby. But you have paid the fund $10,000 in fees. Now suppose the next year the fund has a horrible year, and declines 50 per cent after fees. Your $130,000 investment becomes $65,000, but you have STILL paid $2,600 in management fees (no performance fee would apply in the second year). So, over the two-year period, you have lost a net $35,000, but because of the performance fee in the ‘good’ year, the hedge fund manager has still made $12,600 off of you. The problem here is that performance fees are taken in good years, but nothing is returned to you in bad years. This gives all hedge funds a huge incentive to gamble: After all, it is a one-way trade for them. A good year gets huge performance fees. A bad year doesn’t see them pay these fees back. Ridiculous.
MOST HEDGE FUNDS DON’T EVEN HEDGE
Despite their name, most hedge funds are long-only funds, or long-biased. They may have a small short book, but if the market were to decline most funds are still going to suffer. Again, this is because of the fee structure: markets tend to go up over time, and as noted above fees increase when a fund does well. It is, therefore, in managers’ interests to maximize returns, and this means (usually) being more long than short in their investment book. You may think a hedge fund will protect you in a big market decline, but most will not.
MOST HEDGE FUNDS USE LEVERAGE, SO LOSSES CAN BE COMPOUNDED
We know one Canadian hedge fund that rose 100 per cent one year, and then won all sorts of global accolades for its strong performance. It then went on to lose money, lots of it, in the next five years in a row. An investor over the six-year time frame lost about 60 per cent of their money, despite that giant first-year, award-winning performance. These volatile returns happen because many hedge funds use leverage. This of course enhances returns when times are good, but compounds negative returns when times are bad.
MOST HEDGE FUNDS HAVE SMALL TEAMS, WITH NO SUCCESSION PLANS
In one of my roles in my career at a former company, my job was to look at potential acquisitions of hedge fund companies. We looked at dozens of firms. But, no one wanted to sell. Fees were too high, and selling to us meant those big performance fees would have to be shared. It didn’t matter to these companies that their hedge fund was just one or two people, and there was no long-term succession plan in place. We tried to convince the funds that it was better to sell before the succession issue became a problem, and that investment performance could be improved with a deeper research team. But our arguments fell on deaf ears. Today, most of the hedge funds we looked at are still around, but it is a decade later, and we still haven’t seen many of them put in transition plans. For investors, this should be a concern: Is your ‘star’ manager still motivated, now that they are so rich (from fees)? What happens if your manager is incapacitated, or decides to retire into the sunset?
So, you need to decide: do you want something to discuss at parties, or do you want good investment returns. If it is the latter, you might want to reconsider your hedge fund investments.