Hedge Funds: Look out for hidden charges

Hedge fund managers justify their exorbitant fees by arguing that their methods give them greater opportunities to beat markets. But investors often don't get what they think they are paying for.

One of the main ways in which hedge- fund managers justify their exorbitant fees is by arguing that their methods give them greater opportunities to beat the market. But a recent study by Roger Ibbotson and Peng Chan of researcher Morningstar reveals that investors often don't get what they think they are paying for. The Lipper Hedge Fund Database shows that the sector has returned a seemingly impressive 16.5% a year (after fees) between the end of 1994 and April 2006, ahead of the 11.6% average annual gain for the S&P 500 over the same period.

However, the database does not cover hedge funds that have done so badly they have shut down (1,071 since 2005, says Hedge Fund Research). The results are also skewed by the fact that they are far from comprehensive. Hedge funds are not obliged to report numbers publicly, so if their results present them in a bad light they very often just don't, something that leads to a systemic positive bias. After adjusting for these factors, Ibbotson and Chan reckon that hedge funds have, in fact, returned only 9% a year.

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Jody Clarke

Jody studied at the University of Limerick and was a senior writer for MoneyWeek. Jody is experienced in interviewing, for example digging into the lives of an ex-M15 agent and quirky business owners who have made millions. Jody’s other areas of expertise include advice on funds, stocks and house prices.