Do Investors Get Their Money’s Worth from Hedge Funds?

Hedge FundDon’t forget to factor in costs when evaluating your investments, especially hedge funds.

Key Takeaways

  • A recent study indicates that the average hedge fund return was less than the return of the unmanaged S&P 500 index over a 15-year period.
  • The median fees structure is a 1.5 percent management fee PLUS 20 percent of returns the fund achieves above a certain benchmark.
  • More often than not, any outsize return created by the hedge fund manager’s skills, tools and information access is eliminated by the fund’s high costs to investors.

With the stock market indices at or near their all-time highs and with fixed income yields at historical lows, you may be tempted to dip your toes into the hedge fund waters in search of higher returns. Just make sure you look before you leap.

Most importantly, make sure you’re getting what you pay for since after accounting for management fees, profit-sharing and other costs hedge funds in general appear to add no value.

Do Hedge Funds hedge?

Not really. While their name implies protecting against downside risk most hedge funds are an aggressively managed portfolio of investments that use advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating outside returns for investors.

The term “hedge fund” conjures of savvy traders armed with superior skill and information who are able to take advantage of mispricings in the markets and to earn you above average profits.

Hedge Funds have high costs.

Hedge funds costs are high. The median fees structure is a 1.5 percent management fee PLUS 20 percent of returns the fund achieves above a certain benchmark.

Do Hedge Fund investors get what the pay for?

No! A 2010 study published in the Financial Analysts Journal indicates that after expenses, the median hedge fund delivered performance that’s less than you would earn by investing in a simple, S&P 500 index fund.

Researchers found that from 1995 through 2009, the net after-fee return for the median hedge fund in the study was 7.70 percent compared to 8.04 percent for the S&P 500. Any return created by the so-called superior investment skill of the hedge fund gurus was eliminated by the high costs.  The hedge fund returns did not cover the additional fees.

Their underperformance is due to the high costs described above.

This should not really be a surprise for you. If a smart hedge fund manager was able to earn returns greater than the market on a systematic basis, why would he or she give those returns to you? Pure benevolence? I doubt it.

It reminds me of the saying, “If you want to get rich on Wall Street, don’t invest in a hedge fund–run one.”

Conclusion

First, the evidence is overwhelming: costs matter to every investor. It’s no different when investing in hedge Funds.

Second, there is no free lunch in investing. Be sure to understand the cost structure of your investments. Your advisor should have no qualms about explaining them to you.

If you have further questions about hedge funds or investment costs, please don’t hesitate to contact us.

About Chas Boinske

Charles P. Boinske, CFA, is a 30 year investment management veteran overseeing the strategic direction and portfolio management process for Independence Advisors, LLC. Have a question for Charles? CLICK HERE TO ASK CHARLES

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