Why Hedge Funds Are Overrated

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By Walter Updegrave, RealDealRetirement @RealDealRetire

Ever think you were missing the chance to invest with the most skilled investment managers in the world because you don’t have enough dough to pay the $1 million-and-up minimum investment required by many hedge funds? Well, cheer up. You may not be missing out on all that much.

Given the way the financial press lionizes hedge funds, many investors have come to think of them as magical money machines run by masters of the universe who employ wizardly techniques to rack up spectacular gains. But a new study by two academics in Australia suggests that hedge funds really aren’t all they’re cracked up to be. That’s not because many hedge funds took it on the chin along with regular investors when the market went into its tailspin in August. Rather, that sober assessment stems from something more fundamental—namely, that when it comes to investing, most hedge funds don’t really do anything all that special.

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The study arrives at this conclusion by way of some mind-numbling math that includes references to linear vs. nonlinear risk exposure, GAMs (Generalized Additive Models), GCV (Generalized Cross Validation) and other esoterica. But the Cliff Notes version boils down to this: At the end of the day, most hedge funds deliver the same type of returns you would get from investing in an index fund. Not the same returns—they could be higher or lower. But the returns are largely driven by exposure to the market. So it’s not like most hedge fund managers are giving you access to a unique source of returns.

But here’s the real kicker. The study’s authors also found that the minority of hedge funds whose managers do try to so something out of the ordinary—or, in the language of the study, funds whose returns were the result of “nonlinear systemic risk exposures”—generated gains inferior to those of typical hedge funds. In short, the majority of hedge funds are essentially giving you pretty standard exposure to the market, while those that try to strut their managerial stuff, so to speak, end up with lower returns. So much for hedge-fund mystique.

The idea that hedge funds ain’t all that doesn’t surprise me. Many years ago I did a column on hedge funds for MONEY Magazine that noted, among other things, that the superior risk-adjusted performance claimed by many hedge funds may be an illusion because traditional measures of risk don’t properly take into account the fact that many hedge funds have the potential to deliver far more extreme returns than conventional investments like stocks and bonds.

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And then there’s also the matter of hedge fund expenses, which are blimpish by most any standard. For many years the typical hedge fund fee arrangement has been “2 and 20″—i.e., a management fee of 2% of assets plus 20% of any profits. Investors have reportedly pushed back of late and negotiated to bring those charges down a bit. But we’re still talking about overall expenses that dwarf those in most mutual funds and ETFs, and thus represent a serious drag on returns.

Of course, there will always be some hedge fund managers out there putting up spectacular numbers. That’s to be expected when you have thousands of smart people engaged in any activity. But that doesn’t mean that hedge funds as a group deserve any exalted status or actually live up to their reputation as super-investments run by übermenschen.

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The lesson of this study goes well beyond hedge funds. Any time you run across an investment that purports to have some special cachet or offer a route to big gains with low risk—or you’re at the receiving end of a pitch from an adviser making similar claims— your antennae should go up immediately, especially if you’re being asked to pay bloated fees. Because when you come right down to it, simpler is usually better, and it’s awfully hard to beat a well-balanced portfolio made up broadly diversified low-cost index fund or ETFs.   (9/7/15)

Walter Updegrave is the editor of RealDealRetirement.comIf you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com. You can tweet Walter at @RealDealRetire.

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