Rodney Dangerfield was famous for saying, “I don’t get no respect.” Hedge funds, in my opinion, are the flip-side of Rodney Dangerfield — they get too much respect. In 2013, almost $64 billion of new money was invested in hedge funds, bringing total hedge fund assets to $2.6 trillion.
You might be thinking, “So what? You have to be an accredited investor to buy into a hedge fund.”
Well, guess what? Hedge funds are bypassing the accredited investor restriction in the mutual fund format. According to Morningstar, there are 429 so-called “alternative strategy” mutual funds that either use hedge-fund-like strategies or are funds-of-funds — which hold a portfolio of hedge funds. This is up from 172 such funds in 2008. Invested assets in these mutual funds have increased from $38 billion in 2008 to $160 billion as of February.
Can their appearance in 401(k)s be far behind? Judging by the number of 401(k)s that have added commodity funds in the past few years, I’d have to think that it’s just a matter of time.
It’s also interesting to note that the SEC removed the advertising restriction that’s been in place for hedge funds. This can’t be good news for investors.
The typical hedge fund charges an annual fee of 2% plus 20% of any gain (called a 2+20 fee). The financial media breathlessly praises successful hedge fund managers (at least until they’re convicted of insider trading) — giving naive investors the impression that all hedge funds produce sterling performance. But the data reveals a different story.
Hedge Fund Research created the HFRX Global Hedge Fund Index . Tracking the performance of more than 6,800 hedge funds, the index is designed be representative of the overall composition of the hedge fund universe. Unfortunately, the index suffers from three significant flaws that may lead to erroneously high performance reporting.
The reported data suffers from “survivorship bias” — It doesn’t include the performance of hedge funds that have expired during the reported time period — most of which did so due to poor performance.
Performance reporting is voluntary. If performance has been lousy, no problem. Just adopt the old sibling strategy — “Don’t tell mom!”
Many hedge funds own illiquid assets which aren’t easily priced. Therefore, we must accept the fund manager’s estimate of the asset’s current value. I kid you not.
Let’s compare the performance of the average hedge fund to my Lazy Golfer Portfolio. The portfolio contains five Vanguard index funds — allocated 40% to the Total Stock Market Index Fund /zigman2/quotes/202876707/realtime VTSMX +0.69% , 20% to the Total International Stock Index Fund /zigman2/quotes/210096929/realtime VGTSX +0.77% , 20% to the Inflation Protected Securities Fund /zigman2/quotes/207983017/realtime VIPSX -0.27% , 10% to the Total Bond Market Index Fund /zigman2/quotes/206402661/realtime VBMFX -0.27% and 10% to the REIT Index Fund /zigman2/quotes/206362701/realtime VGSIX +0.06% . Rebalance the portfolio annually on your birthday and ignore Wall Street the remaining 364 days of the year.
Average Annualized Rate of Return Through December, 2013
|1 Year||5 Years||10 Years|
|HFRX Global Hedge Fund Index||6.7%||3.7%||1%|
|Lazy Golfer Portfolio||13.5%||13.5%||7.4%|
With all the money flowing into hedge funds, it should come as no surprise that mutual fund companies have been trying to jump on the hedge fund bandwagon. These new funds are promoted as assets that will diversify your portfolio because their performance won’t correlate with stocks and bonds. A nice idea in theory.
These funds have short track records, high expenses, lack transparency, are tax inefficient and employ strategies that most investors (and their advisers) don’t understand. To add insult to injury, during their short existence their performance has been underwhelming. So how on earth have they attracted $160 billion of investor money?