Overgrown hedges

More and more money has been pouring into hedge funds in recent years, with their total assets topping $3.3 trillion globally in 2017. (In contrast, U.S.-based mutual funds hold more than $16 trillion.)

Many people imagine that hedge funds are conservative, “hedging” their bets when they invest. The truth is, some may be conservative, but plenty of them are quite volatile and risky. And that’s just one of their problems.

Over many long periods, hedge funds, in aggregate, have underperformed the overall U.S. stock market -while charging far higher fees. As Ray Dalio, manager of one of the biggest hedge funds, quipped several years ago: “There are about 8,000 planes in the air and 100 really good pilots.”

According to the Financial Times in May 2016, “Since the market hit its post-crisis bottom in March 2009, passive, lowcost equity fund investors have thrived while hedge fund returns have underperformed the S&P 500 by 51 percentage points.”

For the privilege of investing in hedge funds that often underperform the S&P 500 index, which can be invested in easily and very inexpensively, investors pay dearly. The common compensation system for hedge fund managers is referred to as “2 and 20”: The managers collect 2 percent of investors’ assets each year, whether they deliver gains or losses, and they also take 20 percent of any gains.

Fortunately, most of us can’t invest in hedge funds, even if we wanted to. Like mutual funds, hedge funds pool the money of multiple investors, which is then invested by one or more professional money managers. However, hedge funds are far less regulated, and less disclosure is required of them. They’re also open only to “accredited investors” — folks earning upward of $200,000 per year ($300,000 for couples), or those worth more than a million dollars.

Since hedge fund managers are less restricted, they can take more risks than ordinary investors or mutual fund managers — and many do, investing aggressively in options and futures, shorting stocks, investing with borrowed money and making currency bets. Learn more from the Securities and Exchange Commission (SEC) at sec.gov/ fast-answers/ answers hedge h tm. ht ml.