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The Great Hedge Fund Myth

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Things are looking pretty bleak for the "masters of the universe": hedge fund managers. According to a blog by Jeff Macke, host of Yahoo's Breakout, the average hedge fund was up 3.8 percent through August. Those are pretty dismal returns considering the fact that the S&P 500 index was up 11.9 percent.

It is not entirely clear what investors in these funds are getting for the $2 trillion or so they have invested. Macke predicts that 2012 may turn out to be the third year in a row of underperformance for hedge funds.

He notes the high fee structure of these funds, which is typically 2 percent of assets plus 20 percent of profits. Then he goes off the rails.

First, he observes that the 2 percent is really chicken feed compared to the potential profits from the 20 percent. He fails to state that the mutual fund industry is doing just fine charging, on average, significantly less than 2 percent to manage the funds of investors, with no bonus compensation for profits. The mutual fund industry (excluding hedge funds) is one of the most profitable sectors in the country. According to Management Practice, Inc., the average return after all costs of mutual fund companies, is "about 30 percent of revenue." Apparently, that's not enough for hedge fund managers.

Next, he says that hedge fund managers have two choices. They can "admit defeat" by telling investors returns would have improved "but I refused to take part in this bogus rally based on little more than a possibly corrupt Fed chair dumping money into the system". Or, they could "chase" returns by picking stocks he believes are likely to outperform like Amazon, Apple, Google, and others.

He doesn't mention the third option. Concede you are in business to maximize your profits at the expense of your investors. You don't have any demonstrated ability to deliver outsized, risk-adjusted returns. Why not just fess up?

The problems with hedge funds are well known to anyone who does due diligence. Here's a summary:

They are risky. Because they have the freedom to use leverage, the possibility of losses as well as gains are magnified. One National Bureau of Economic Research study found that, "The risks facing hedge funds are non-linear and more complex than those facing traditional asset classes...such risks are currently not widely appreciated or well-understood."

The returns are dismal. Simon Lack, in his excellent book, The Hedge Fund Mirage, reached the devastating conclusion that hedge fund investors as a group would have been better off if they had simply invested in Treasury bills, the quintessential risk-free investment.

The high fees are a barrier to decent returns. Another article found that in at least 80 percent of cases, the after-fee alpha for hedge funds was negative. The hedge fund managers did great. The investors would have been better off in an index fund.

They are illiquid. When things go south, you can be stuck in a hedge fund for a protracted time period because of restrictions on withdrawals.

Macke's suggestion that hedge fund managers seek to bolster their returns through stock picking flies in the face of a wealth of contrary data summarized here. Stock pickers advised investors to buy Lehman Brothers, Washington Mutual, Worldcom, Enron, and many other companies that subsequently went bankrupt. There is no credible data indicating anyone has stock picking skill when you account for luck. Real market experts, who have spent their lives studying the capital markets and writing books and academic papers setting forth their extensive research, have concluded that stock picking is a loser's game. These scholars include William Bernstein, Nobel Laureate Merton Miller, Zvi Brodie, Burton Malkiel, and Michael Jensen. You can find quotes from them on this subject here.

Here's my challenge to Mr. Macke: I have shown you my peer-reviewed data. Where's yours?

You should make the same inquiry of anyone who tells you to buy a hedge fund or engage in stock picking.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.

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