- Returns are underwhelming. Academic studies have repeatedly shown that hedge funds underperform the stock market. One study that examined a period between 1995 and 2004, for instance, found that the average hedge fund generated a 9.1 percent annual return, which lagged the Standard & Poor's 500 Index by three percentage points a year. Significantly, the survey period included the nasty bear market of 2000 to 2002, which is when hedge funds are supposed to perform best.
It's ridiculously easy to find years when the hedge funds played laggards. In 2003, for instance, the HFRX Global Hedge Fund Index, an industry benchmark, returned 13.4 percent, which certainly sounds respectable until you look at how the competition did. The Standard & Poor's 500 Index was up 28.7 percent, international stocks soared 39.2 percent, emerging markets turned heads with 56.3 percent and the REIT benchmark surpassed 36 percent. The next year, the hedge fund benchmark dipped into negative territory (minus 2.7 percent) and got its fanny smacked by the major asset classes again.
The published returns of the hedge fund industry, by the way, are artificially high. The statistics, for example, don't take into account the burnouts. One study concluded that the median lifetime of a hedge fund is a mere 5.7 years. The most famous example is the notorious Long Term Capital Management, which lost 92 percent of its capital between October 1997 and October 1998 and almost triggered a global financial crisis. The fund, which was run by some of Wall Street's brightest stars, didn't report its final figures before pulling its plug. Plenty of other spectacular losers don't, either, which skews the performance figures.
- The risks are high. The volatility of hedge funds can be far more dramatic than garden-variety mutual funds, says Larry Swedroe, the director of research at Buckingham Asset Management in St. Louis, who is finishing a book on alternative investments. What can happen, he says, "is the opposite of a lottery ticket, where most people lose, but losses are small and the few winners win big." Hedge funds are more likely to produce exceptionally good returns and exceptionally horrendous returns with greater frequency.
I'd suggest that most San Diego County retirees would forfeit the chance of their pension fund drilling into a huge gusher when the alternative is watching their fund dig itself a hole halfway to China.
- Hedge funds gouge investors. Imagine that a pension fund has $175 million to invest. The pension board members could direct the money into index funds that cost 0.2 percent a year or less and capture market returns with moderate risks through a well-diversified portfolio. Or they could listen to their consultants and sink that money into hedge funds that, for starters, will probably assess a fee ranging from 1 percent to 2 percent. If the board chose the preferable index route, the fund would be charged $350,000 or less a year. In contrast, the tab for a dicey hedge fund assessing a 2 percent fee would be $3.5 million.
The price of admission to a hedge fund, however, is even stiffer. In our example, a fund manager isn't going to be pleased if the firm only pockets $3.5 million. As an incentive, hedge fund managers typically demand a 20 percent cut of the profits. It's this porky pig compensation that has prompted many mutual fund managers, whose pay isn't as outlandish, to create their own hedge funds.
Then there are the miscellaneous expenses, which one study of 100 hedge funds pegged at an average of 1.95 percent. And that doesn't include trading costs, which can be considerable. Tallying these costs reminds me of a kitchen remodeling project gone wild. And who needs that?