Why Hedge Funds Are a Lousy Investment

The one thing you can guarantee when investing in hedge funds is, the managers are going to get rich...even if the investors don't.

Don't get suckered into believing you will be taking your investing strategy to the next level. The difference between reality and perception is stark and the only people sure to win are the managers themselves.

The annual report on the 25 highest paid hedge fund managers came out last week and the results were no less outrageous than they have been for years: $14.1 billion in pay and paper profits on their own investments in 2012, slightly down from 2011's $14.4 billion, according to Institutional Investor Alpha's Rich List.

You can do the math - the average top 25 hedge fund manager took home $564 million in 2012, down from $576 million in 2011.

The big question is, what did these managers do for their investors to earn these kinds of sums?

After all Lloyd Blankfein, CEO of Goldman Sachs, took home a measly $21 million.

In 2011, the average hedge fund lost money, even before the $14+ billion creamed off by the top 25 managers. In 2012 the average hedge fund made a weak 6.4% for its investors, according to Hedge Fund Research.

That means it trailed a passive portfolio of 40% bonds and 60% stocks by almost 5 percentage points. This is one of the big reasons I have disliked hedge funds for so long. They seem built more for managers amassing wealth than doing so for their investors.

The Devils in the Details

One difficulty with the list is that it counts both the "carried interest" percentage of the fund's profits that the management company received (and that is taxed at capital gains tax rates of 15% in 2012 - 20% in 2013 -- rather than at income tax rates) and the return on the manager's own investment in the fund.

To see how this works, suppose a manager has a $10 billion fund, and he has an investment of $1 billion in the fund. Then suppose the fund has an excellent year, making a 30% return. The management company will receive as "carried interest" a return of $10 billion x normally 20% of the profits of 30%, or $600 million.

The manager will receive 24% (30% minus the 6% "carried interest") on his own $1 billion, for an additional $240 million. His total return, assuming he owns 100% of the management company and employs nobody but unpaid interns to manage the fund, will be $840 million.

In practice, you have to pay the help something, and there's probably an office, but those may both be charged to the fund as expenses. But it's nice to get paid twice all the same.

That accounts for the average manager, but it doesn't account for the top guy, David Tepper, who runs the $15 billion hedge fund Appaloosa, who took home $2.3 billion last year. Granted, Appaloosa investors had a very good year, making 30% after fees, according to the Financial Times.

But using the calculation above, if Tepper had $2 billion invested in the fund, he should have taken home $2 billion x 30% plus $15 billion x 7.5%, or $1.725 billion. The fact that he made an extra $575 million above that suggests that Appaloosa's fee structure is even more generous than the norm.

As for 2011's leader Ray Dalio of Bridgewater ($4.3 billion in 2011), he had to be contented with a measly $1.9 billion in 2012. But then his leading hedge fund, Pure Alpha, is said by ZeroHedge to have achieved a return of only 0.8%.

Bridgewater's funds under management total $142 billion, but even so a fee of $1.9 billion (not much of which can have come from fund's return) for underperforming the market by 10 full percentage points really does seem a teensy bit excessive. And Pure Alpha likely isn't having a great 2013 either, since it has a large long gold position, currently down some 20% this year.

It's About Forbes, Not the Markets

A number of hedge fund guys feature prominently on the Forbes 400 "rich list" - I count eight of the top 40, headed by George Soros at #15, whose businesses consist mostly of hedge funds or private equity funds.

We can largely thank Ben Bernanke for this; his "funny money" and that of Alan Greenspan before him have enabled hedge funders and private equity managers to borrow at almost zero interest cost in real terms. Naturally, if you can borrow at zero, the best deal is to leverage yourself to infinity and invest in assets, any assets, provided they make some kind of return.

That's why the Forbes Rich List, which 30 years ago consisted mostly of inherited money and a few industrial titans, is now dominated by the get-rich-quick crowd (there are a few casino owners on there too).

I hope you're getting the message: Hedge funds are a lousy investment.

You can get a good exchange traded fund or managed equity fund with fees and expenses of only 1% or so and no front-end load - Vanguard's are the cheapest but there are several other good investment management groups - whose CEOs are paid less than Lloyd Blankfein and a tiny fraction of the hedge fund titans. With an ordinary mutual fund, you will get just as much management skill as with a hedge fund, and in years like 2011 and 2012 you'll achieve a better return.

Don't imagine either that when your broker comes to you with a hedge fund proposition and tells you that you can join "the elite" by investing that there will be any special treatment once you've invested. Even with a $1 million investment, you represent maybe an hour or two's earnings for the hedge fund chief - his real money comes from places like the Harvard Endowment, with $30 billion under management

Of course, the Harvard Endowment would also do better by putting the lot into a few index funds.

But then its managers, in turn, would have to be remunerated like ordinary people - which would never do!

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