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Posted on March 15, 2007 -
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By John Reizner |


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Hedge funds have become a fad on Wall Street these days. Many banks, including one where I have my money, are rushing to say that hedge funds should be in many wealthy investors' portfolios, as an "alternative" investment that can balance out your portfolio. The sellers of such investments say that in a general market swoon one's overall portfolio losses might be partially mitigated by profits from the hedge fund's short holdings, if there are any. I will say however, that most fads end badly.

Hedge funds are investment vehicles which employ strategies in the financial markets such as betting on the both the rise or decline of equities (long and short positions), option strategies, derivatives, debt securities, or any position which the manager believes may be profitable. There is often with these vehicles an emphasis and a culture of short-term and ultra short term investment, which may be inherently riskier. Hedge fund managers often employ complex methods to increase the likelihood of achieving a high return on investment, but which often involve assuming greater risk. These managers sometimes use leverage to attempt to increase their returns.

Richard Bookstaber, in his volumeA Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovationdemonstrates that he "has seen the ghost inside the machine" of hedge funds and their masters, who instead of making the financial system safer, came to be part of its unraveling.
 
I believe the following four reasons support the proposition that you should not invest in hedge funds:
 
Reason number one: high fees siphon away a chunk of your profit. Hedge fund managers and distributees may charge as many of three different types of fees on your investment dollars. There may be an initial sales charge which would take out a percentage, for example, 4%, of your investment dollars as the cost of entry or sales compensation. Second, there typically is a management fee, which might be 2% annually for example, which is charged to cover the operations of the fund. Third, there is usually a performance fee incentive, often 20% of your profits, which goes to the manager. It is no wonder with all these high fees, that many banks and individuals are so high on hedge vehicles. In fact the sponsoring manager or bank offering or managing these funds face a number of conflicts of interests inherent in this structure. 
 
Reason number two: many hedge funds employ leverage, using borrowed money or derivative instruments, to invest in order to magnify the returns to their investors. Of course, using borrowed money or derivative instruments to invest can work against you - should the funds positions go sour, then losses are increased.
 
Reason number three: the performance of hedge fund vehicles as a class of investments may not be as great as generally thought after you consider the hedge fund failure rate. There may be many well-run hedge funds, though no one is immune from failure or closure due to poor performance. Julian Robertson, a top level and eminent operator, closed his fund after holding onto positions that went against him as the millennium bear market burst the technology bubble of the late 1990's. Spectacular hedge fund failures such as Long Term Capital Management and more recently Amaranth, illustrate the speed and extent of capital loss that can occur in such investment vehicles, particularly those that employ significant leverage. You can literally wake up one morning with your profits gone or showing deep losses. Do you want to take that risk? However, many funds close down because the operators do not want to continue running the business. Also, some operators may not be able to attract enough money, and close down.
 
Reason number four: Hedge funds often pursue an investment program with a short term time horizon. I have always believed trading with a very short term outlook, often intraday, is highly speculative. I believe there are only a small number of managers savvy enough to make investing in a hedge vehicle with such time horizons consistently worthwhile. Why take unnecessary additional risk with earning a half point in a day, or not, with borrowed money or derivative instruments, when one can more reasonably invest in select equities or mutual funds that may multiply your original investment many times over the long term?

 

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