Hedge funds are a bit like a movie star whose latest films have
flopped, but who still retains A-list status. These funds still
have a certain cache among individual investors, who can feel like
high rollers by participating in a vehicle not available to the
average investor. They have also been eagerly pursued by
institutional investors, who have been increasingly coaxed into
alternative investments as a potential cure for portfolio results
that have lagged behind goals.
The question is, do hedge funds deserve all the buzz? To put it
more specifically, do hedge funds deserve a place in your
investment portfolio?
A closer look at hedge funds
Here are six reasons you ought to think twice before investing
in a hedge fund.
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The fees are over-sized.
Hedge funds often charge annual management fees of around 2
percent. That may have been tolerable during the high-flying
1990s, but with interest rates now near zero and weak global
growth reining in stock returns, 2 percent is just too big a
hurdle to overcome.
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You'll probably have to share your profits.
That 2 percent might seem like a fat enough fee, but besides
charging that amount off the top, it is customary for hedge fund
managers to also take 20 percent of any profits the fund makes.
As with the high annual management fee, this profit participation
is a practice that's ill-suited to today's
low-return environment
, and stacks the odds too heavily against investors.
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They don't constitute a well-defined asset
class.
Sophisticated investors seek asset-class diversification so
different parts of their portfolios can play distinct roles. The
problem is, even though hedge funds are often categorized as an
asset class, they don't really fit into any sort of consistent
definition. Some invest long while others short stocks; some
specialize in commodities while others make interest rates bets.
Part of the appeal of hedge funds is their investment
flexibility, but this makes them behave more idiosyncratically
than the components of a typical asset class.
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Too many players have gotten into the act.
Hedge funds are supposed to be something of an elite investment,
using strategies that are flexible enough to gain an edge on the
financial markets. However, according to The Economist, there are
now 8,000 fund managers trying to handle more than $2 trillion.
At that size, the hedge fund market no longer seems elite nor
flexible.
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They haven't delivered.
The Economist reports that after fees, hedge funds have returned
an average of 17 percent over the past decade. That's 17 percent
in total, not per year. To put that in perspective, as low as CD
rates are, you could have
earned more in short-term CDs
over the past decade.
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'Funds of funds' only compound the problem.
As the hedge fund industry has grown, a thriving business of
putting together funds composed of several hedge funds has
developed. The idea is to provide scrutiny and make it easier for
investors to access multiple investment styles. More often, the
reality is that this simply adds a layer of fees and makes the
investment approach less transparent.
In the hands of managers with a well-established track record
and a
clearly defined investment approach
, hedge funds really can be something special. More often, though,
they turn out to be below-average performers at above-average
prices.