Saturday, November 6, 2010

Hedge Funds: The devil is in the fees

We have all heard stories of hedge fund managers making huge bets that paid off big for their investors and, of course, themselves. We also know of the high fees charged by hedge funds and the risky activities engaged in by quite a number of hedge funds.

Hedge funds typically charge fees of 2% on the principal and 20% on the increase in the value of the principal (if any). This is, obviously, very high. Just think about it this way:

From 1989 to 2009, the compounded annual growth rate of the S&P 500 was about 9.25%. If a hedge fund manager charging the standard fee (2% on the principal and 20% on the increase in the principal’s value) for his expertise were to help his investors achieve average stock market returns, his fund would have to return about 14% (the figure I came up with may be a bit off, but whatever it is, the fees are significant, and are a definite drag on performance).

People that invest in hedge funds will, of course, demand higher than average returns. So, assuming that an investor would be happy earning returns of 2% above the returns of the average stock (I would demand more), a hedge fund manager would have to get returns of 16.5%. This kind of returns is pretty hard to achieve long-term, and even if some top fund managers can sustain this kind of returns, I don’t think the average fund manager can generate for his investors long-term returns in excess of 16.5%. Warren Buffett wrote in one of his letters to shareholders that fees and commissions will cause a lot of investors to earn below market returns. 

Quite a number of hedge funds engage in activities that might be too close to market timing and speculation; not things that any value investor would like to be a part of. While market timing can result in good returns if the fund manager is lucky, it can also result in very heavy losses if the fund manager makes a bad bet.

There are, however, hedge fund managers like George Soros that have generated good long-term returns for their investors by employing strategies that might seem speculative (I don’t know if Soros is still active as a fund manager, but you get the point). And while I don’t believe in speculation, I can’t argue with success. I just won’t invest in things that I don’t understand (especially if someone else is managing my money), even if it means that I would miss out on a lot of profits. If I had to invest in a hedge fund, I would pick a fund run by someone that I really respect, and who employs sound value investing strategies.

I generally do not believe in investing in hedge funds because of the high fees they charge, and because I love valuing and investing in stocks on my own. But if I do come to know about a hedge fund manager that I believe will be the next Warren Buffett or Peter Lynch in terms of putting money to work, and if I have already amassed enough wealth to safely meet the steep minimum investment requirement of most hedge funds, I might seriously consider putting a significant portion of my money in his or her fund.

Thank you for reading and may you always sustain good returns on your portfolio. Take care and have a great day!

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