Lynn O'Shaughnessy

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:

- 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?


Lynn O'Shaughnessy

Lynn O'Shaughnessy is the author of Retirement Bible.

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