The Problem with Hedge Funds

Last year the stock market languished in negative territory for the first 10 months before breaking out. So far this year, the stock market again appears to be stalled with many Wall Street analysts prognosticating modest single digit returns for 2005. What’s an investor to do? Some investors are turning to hedge funds as a way to get back to double-digit returns. A hedge fund is a loosely regulated private investment that is often shrouded in secrecy. Often only available to accredited investors with $1 million-plus net worth or $200,000 per year income, the popularity of hedge funds has attracted brokerage firms such as Charles Schwab & Co. that are now forming funds with minimums as low as $25,000 for non-accredited investors (SWHEX).

So what’s the big attraction for taking part in these so-called ‘super capitalist’ ventures? Most recently, it’s been the superb returns that some of these steroid-enhanced-managers have put up. Although hedge funds employ a dizzying array of strategies, including trading in equities (both long and short), currencies, distressed debt, and credit derivatives, some hedge funds will go so far as to seek to take over the various companies they invest in. Leverage is also largely employed on a regular basis, as well as the ability to short investments on a regular basis. High returns have caused hedge funds to become the darlings of the financial press. For example, ESL Investments hedge fund manager Edward Lampert, earned 69% for his investors over the past year (29% annually since the fund’s 1998 inception). He is best known for the recent merger of Sears Roebuck & Co. and Kmart. James Simons’ Medallion Hedge Fund posted annualized returns of 34% since its 1998 inception. With returns like these, understandably, hedge funds have attracted a lot of interest from investors.

However, you should be aware of two significant drawbacks to hedge funds before you invest in them:

  • Lack of transparency. Most hedge funds do not disclose to the public or their investors what the manager is investing in. In other words, the investors must make the ultimate leap of faith in the hedge fund manager’s ability. As an investor, you are never certain how much risk you are undertaking. History suggests that brains alone are not necessarily enough. In 1994, a group of Nobel Laureates and experienced securities traders formed a hedge fund called Long Term Capital, which received lavish praise from the financial press along with $1.3 billion of investor money. Within a mere four years, the fund teetered on the brink of bankruptcy and threatened the collapse of the world financial markets. The Federal Reserve had to step in and orchestrate a $3.5 billion rescue. Understanding what you are investing in is vitally important.
  • High fees. We all know mutual funds charge fees, stockbrokers charge fees or commissions. We expect to pay for professional help. But the fees charged by many hedge fund managers border on outrageous. The typical hedge fund charges 1%-2% annually based on your capital balance plus 20% of the profits. But fees can be much higher. For example, James Simon’s Medallion Hedge Fund charges a 5% annual management fee plus a whopping 44% of profits. As an investor, to some extent, you don’t care what the manager earns in fees as long as you are making above average returns. But there are thousands of hedge funds and only a handful have produced stellar returns. Last year alone, an estimated 270 hedge funds terminated operations due to poor performance.

You should also be aware that many hedge funds do not allow you to withdraw your funds for extended periods of time, some as long as five years. One notable benefit of hedge funds is their returns have a low correlation with the broad stock market, thus enhancing diversification while reducing overall portfolio volatility. Hedge funds may be worth considering but you should first do a great deal of due-diligence before investing in them.

My thanks to my partner, Scott Lee for his assistance with this article.