‘Think twice before moving into hedge funds’
Hedge funds are sold on the basis that they can protect capital during market downturns while generating above-average returns in normal market conditions. But events over the past year have proved these claims to be untrue. At the recent series of meetin
Hedge funds are not all they are made out to be, Piet Viljoen says. Over the past year, when markets tumbled and hedge funds were supposed to protect investors from the downside, they underperfor med balanced unit trust funds by 5.1 percent for the year, he says.
“Generally, simple balanced unit trust funds are a very good alter native to hedge fund investments, as they earn you comparable returns, but at a lower level of risk than most hedge funds,” he says.
Viljoen says that although hedge funds may at times offer higher returns, they have a greater risk than balanced funds of under-performing and even collapsing.
On the accompanying graph, which shows probabilities of returns, the blue line shows the monthly average retur ns you could expect from a balanced portfolio. The red line shows the monthly average returns you could expect if you added a hedge fund to your portfolio. Your monthly average returns are higher with the hedge fund and you get lower returns less often.
However, Viljoen says that if you look at the left-hand side of the graph, the red line is slightly higher than the blue line.
“At this point, hedge funds are more likely to lose large amounts of money. Although this is extremely rare, extremely negative events seem to occur more often with hedge funds than with plain vanilla funds. As Warren Buffett says, a long string of impressive numbers multiplied by zero equals zero,” he says.
The price you pay for earning higher returns with a hedge fund is the possibility of losing all your money if the fund collapses, he says.
Hedge funds are considered riskier investments largely because hedge fund managers use gearing. This means they borrow money to buy more shares, unlike managers of ordinary funds, who are not allowed to use gearing.
Viljoen says that when it comes to investing, people often do the exact opposite of what they would do in everyday situations.
“For example, in investments, when prices go up, everyone wants to buy, and when prices fall, everyone wants to sell.
“But if the price of bread doubled, you wouldn’t exactly see people queuing up to buy bread. In the case of a staple item such as bread, people react more rationally.
“When the market goes up, hedge fund managers become superheroes, because they offer high returns, and everyone wants to invest in hedge funds. But when there is a bear market, hedge funds close and investors lose interest in them,” Viljoen says. In the past year or two, there have been a number of spectacular hedge fund failures. For example, commodity trader Amaranth lost 60 percent of its assets under management in one month, and, in 2007, Bear Stearns credit funds collapsed. Locally, the Evercrest Aggressive Hedge Fund, worth about R120 million, collapsed, and investors lost about 60 percent of their capital.
Viljoen says whenever there is huge excitement about a particular type of investment, crooks come out to play. A prime example of this is the recent Bernie Madoff scandal in the United States.
He says that although there are many very poorly managed hedge funds, there are some good ones too.
Statistically, hedge funds add to your investment portfolio’s returns and diversify your risk to some extent.
“Smart people with calculators can show you quantifiable and measurable returns for your portfolio, but in practice this is subject to certain risks, which are often misrepresented to you,” Viljoen says.
He says too often investors have no idea of what a hedge fund is or how it works, but they invest in it based on the “fantastic returns” they are promised by an enthusiastic hedge fund manager.
“It’s tantamount to paying a high price for a sealed black box when you have no idea what’s inside,” Viljoen says.
LUCRATIVE FOR MANAGERS
Viljoen says investors often overlook the huge benefits of hedge funds for hedge fund managers.
Fund managers of normal funds, such as unit trusts, charge you about one to two percent of your assets a year in a highly regulated investment environment. Banks generally earn around one percent on their asset base, also in a highly regulated environment.
Hedge fund managers, on the other hand, earn two percent a year plus performance fees, and are very lightly regulated, he says.
“It’s no wonder a number of fund managers move into hedge funds. It’s not because they are better managers. It’s because they get paid more and are regulated less. Most hedge funds are little more than an alternative remunerative scheme,” Viljoen says.
The bottom line is that hedge funds are risky investments that are largely unregulated.
The golden rule of investing is that you should understand what you are investing in. If you don’t understand an investment, you should not invest in it.
“Your duty as an investor and a consumer is to do your homework. It is your responsibility to fully check any investment you make,” Viljoen says. “Neither the government nor any regulator can save you from unscrupulous operators.”
He says the odds, unfortunately, are stacked against you, the investor.
“There are a lot of clever people out there trying to part you from your money. If you do want to invest in a hedge fund, you should get proper financial advice from an ethical independent financial planner who is not affiliated to any one investment company,” he says.
Piet Viljoen of RE:CM
CROOKS COME OUT TO PLAY