For the last several years, I have been preaching to those few with the kindness and fortitude to tolerate my rants that hedge funds are an absolute scam and will eventually be viewed in our collective rear-view mirror with the same hungover disbelief with which our society regards the dot-com bubble and the real estate crash. "I did what last night?" has become "I bought what last year for how much?" Ugh, I need an aspirin.
If you think Pets.com and Inland Empire real estate were overpriced garbage, consider your average hedge fund. Your average hedge fund will charge you an annual fee (usually about 2% of assets) for the privilege of putting your money in their hands. They will then take a percentage of any profits (usually about 20%). It's called two and twenty, and it is the greatest racket in the world.
If the fund makes money, you get your piece minus your substantial costs. If the fund loses money, you get a ringing phone, unreturned emails, and potentially a visit from an SEC agent with tragic news. I regret to inform you your investment was killed in a mortgage deal in Boca Raton.
It is simply astonishing to me that people will pay these levels of fees, only to be told that their money is locked up and cannot be returned. For $10 a trade, Schwab will do my bidding and send me money on request. Why would you pay more for less access to your own money?
There is something else to understand about the average hedge fund. The trader is, most likely, pretty much average. Traders move back and forth between Wall Street firms and hedge funds like the swallows of Capistrano. After a couple of years of successful trading on a Wall Street desk, a trader puts up a shingle, raises some money, and then does basically the same thing he did for the bank. Except as generous as payouts have historically been at banks, hedge fund payouts are simply ridiculous.
The real problem is that the incentives in most hedge funds are designed to benefit the fund, not the investor. Because their payout is linked to upside performance, funds are incentivized to leverage up and swing for the fences. And because most performance fees are calculated annually, funds are incentivized to do everything they can to make a single year's numbers look good. With enough capital, one good year can set a trader up for life, and should the position blow up spectacularly in following years, there is usually no mechanism to claw back the ill-gotten bonus. A case in point.
There are excellent money managers out there, but there are really only a handful that are consistently successful. The best of the rest, on aggregate, are probably only a few percentage points better than the rest of the market herd. By the time you remove your annual fee and 20% of your upside, you have pretty much wiped out that advantage. Add in the risk of either fraud or a massive loss, and investing in hedge fund seems like a loser's game.
The biggest losers lately seem to be pension funds. Eventually someone is going to ask why pension funds are paying these ridiculous fees to funds (and funds of funds) for results that are pretty ordinary. The retirement capital of millions of people is being used to finance highly leveraged trading that is making a few people enormously rich at enormous risk. I don't often say this, but where the hell is the AARP when you need them?