How would you react if some guys with impressive credentials approached you with this financial pitch:
We can make you unfathomable riches, but we can't divulge how we'll do it. We're pretty much unregulated because wealthy investors, pension funds, endowments and other institutional investors should be smart enough to choose their tango partners. If you sign our dance card, we'll charge you exorbitantly high fees. Also, prepare yourself to write fat checks to the IRS because our traders are whirling dervishes who don't give a hoot about your taxes.
Sound appealing? Most people hearing this would probably be screeching out of the parking lot before the financial wonks finished their presentation. But this eminently sensible reaction is rarely witnessed in a world where the allure of exclusivity and easy money turns the brains of so-called sophisticated investors into oatmeal.
What these investors can't resist, of course, are hedge funds. The powerful mystique surrounding hedge funds has turned their managers into the alchemists of the 21st century. And their wealthy acolytes have followed. In 1990, there were 530 hedge funds with $50 billion in assets; 15 years later, investors had sunk roughly $1 trillion into more than 8,000 hedge funds. The hedge fund kings of Greenwich, Conn., and other tony ZIP codes, however, are no more likely to turn a lead pipe into a gold bar than they were when Thomas Aquinas was preoccupied with his theological writings.
Yet this black-box investing approach has generated so many positive press clippings that it catches victims unaware when the trap door opens. That certainly seems to be what happened to the officials overseeing San Diego County's retirement plan, who apparently invested $175 million last year with Amaranth Advisors' hedge fund. In just a couple of weeks, the hot hedge fund turned ice cold as it managed to lose billions of dollars.
The steep loss isn't a surprise. Wall Street is littered with the ashes of thousands of hedge funds. Just last year, 850 hedge fund called it quits. What's scarier, according to media accounts, is that the county's retirement system had 20 percent of its money sitting in hedge funds.
Whether you're a member of a pension board or a wealthy investor who loves the idea of investing in something that the average Joe can't, you need to know why hedge funds can be poison Kool-Aid. Here are just a few of the reasons to stay far, far away: