Don’t buy the hedge-fund hype

Hedge funds have a habit of turning clients’ money into their own money, says Max King. Steer clear.

952_MW_P18_Funds

Ackman's Pershing Square isn't really a hedge fund

© 2015 Bloomberg Finance LP.

Hedge funds have existed for many decades, but it was in the late 1990s and the early years of the new millennium that they first attracted popular attention. Stripped bare, hedge funds are just flexible investment funds that seek to provide consistent long-term returns while protecting their investors from the volatility of financial markets. The popular perception, however, is far more alluring.

Hedge funds, operating from discreet offices in Mayfair, Geneva and Manhattan, promoted themselves as exclusive investment clubs taking financial innovation to the limit. They made use of financial instruments and strategies such as futures, options and short-selling (betting on a price decline by borrowing an asset and selling it in the hope of buying it back more cheaply later). They jumped between equities, bonds, currencies, commodities and assets such as carbon permits beyond the horizon of conventional investors. And by swinging from heavy borrowing to accumulating piles of cash, from "net long" to "net short", they opened up new dimensions of investment.

Returns from the successful funds (the only ones you heard about) were spectacular, apparently justifying the huge fees, conventionally "two & 20", a 2% annual management fee and a 20% levy on all gains. Private banks, endowment funds and the rich queued up to invest, with the hoi polloi excluded by high minimum investments and their being open only to "sophisticated" investors, given that they operated offshore and outside financial-market regulations. This added to their mystique.

Hedge funds rely on luck, not skill

As the returns rolled in, assets and the number of funds kept growing. New managers, eager for the lucrative fees, cast their nets wider to haul in investors. Pension funds, happy to sacrifice market returns in the good years for downside protection in the bad ones, piled in. Investment trusts managed by hedge fund "masters of the universe" were floated on the stockmarket to allow "unsophisticated" investors in. But when exclusive clubs for the rich open their doors to all passers-by, it's best to walk past quickly. Funds found it increasingly difficult to generate positive returns while avoiding losses as a growing amount of capital chased after a fixed amount of market inefficiency. The composite index of performance compiled by Hedge Fund Research has underperformed the S&P500 Index for ten years in a row, with respective average annual returns of 4.2% and 13.7%.

Hedge funds can give pedestrian returns

Hedge-fund managers have been proficient at turning their clients' money into their own. Mark Dampier of Hargreaves Lansdown describes them as "glorified gambling funds that take absurd performance fees from investors when they occasionally do well, and then close when the going gets tough". Steer well clear: only the managers get rich.

Recommended

Stockmarket crash: is the “superbubble” heading for a “superbust”?
Stockmarkets

Stockmarket crash: is the “superbubble” heading for a “superbust”?

America's Nasdaq stock index is down by more than 10% after soaring to all-time highs in a "superbubble". Are we about to see a "superbust" stockmarke…
21 Jan 2022
Invest in VCTs: tax-free investments set to break records
Investment strategy

Invest in VCTs: tax-free investments set to break records

Generous tax breaks make VCTs – venture capital funds – an attractive supplement to pensions.
21 Jan 2022
Barry Norris: investing for a post-pandemic world
Investment strategy

Barry Norris: investing for a post-pandemic world

Barry Norris, manager of the Argonaut absolute return fund, explains what the investment landscape looks like in a post pandemic world, with the end o…
21 Jan 2022
What will happen to the price of gold in 2022?
Gold

What will happen to the price of gold in 2022?

Gold is traditionally the go-to asset during inflation. But with inflation at 30-year highs, it has gone nowhere. Dominic Frisby investigates why, and…
20 Jan 2022

Most Popular

Ask for a pay rise – everyone else is
Inflation

Ask for a pay rise – everyone else is

As inflation bites and the labour market remains tight, many of the nation's employees are asking for a pay rise. Merryn Somerset Webb explains why yo…
17 Jan 2022
Temple Bar’s Ian Lance and Nick Purves: the essence of value investing
Investment strategy

Temple Bar’s Ian Lance and Nick Purves: the essence of value investing

Ian Lance and Nick Purves of the Temple Bar investment trust explain the essence of “value investing” – buying something for less than its intrinsic v…
14 Jan 2022
US inflation is at its highest since 1982. Why aren’t markets panicking?
Inflation

US inflation is at its highest since 1982. Why aren’t markets panicking?

US inflation is at 7% – the last time it was this high interest rates were at 14%. But instead of panicking, markets just shrugged. John Stepek explai…
13 Jan 2022