So you think you want to play with the big boys — hedge funds, that is?
During the tech run-up in the late 1990s, many retail investors were envious of the well-heeled folks who could afford to plunk down a minimum of $1 million to join investors who enjoyed tremendous returns from investing in exclusive hedge funds.
According to the Hennessee Group, it wasn’t unusual to see gains of 60%, 70% — even 80% in 1999. But that all changed with the tech bust in 2000. The stock market fell off a cliff and hedge fund returns plunged — many into the negative.
However, they bounced back pretty darn well during the stock market’s bull run from 2003-07. Managers routinely posted annual returns — very healthy gains such as 69% in Latin American funds, 45% in small-cap stocks and 36% in financials. As you might expect, hedge funds proliferated during those four years, growing to more than $1.4 trillion in assets.
Industry assets shrunk during the recession, but have rebounded to more than $2 trillion today.
That certainly sounds like the hedge fund industry is booming, doesn’t it? And the growth in assets surely are.
The returns? Not so much.
What many investors don’t know is that the last time that hedge funds outperformed the S&P 500 was in 2008, when they declined 20% compared to S&P’s 37% drop. And since the meltdown in 2009, their performance has decidedly lagged that of the broader market.
Hennessee says that in 2011, while the S&P 500 returned 12% to investors, 60% of hedge funds actually lost money. And so far this year, they’ve returned a mere 4.6% — minus fees.
And speaking of fees, they are one of the reasons that hedge funds have performed so poorly. Most hedge funds charge their investors an average 2% of assets, as well as 20% of their gains, but some superstars have levied fees as high as 5% and performance fees of nearly 50%!
They were able to get away with those ridiculous fees as long as they were making stellar returns, but former hedge fund investor Simon Lack reports that in his study of the 12 years ending in 2010, management fees ate up most of the gains. In fact, the average investor in a hedge fund received just 3% of the average stated hedge fund return!
Sure, there are exceptions. Eddie Lampert’s ESL Investments saw a 36.9% rise in its eight largest holdings during 2012’s first quarter. And Chase Coleman’s Tiger Global earned 27.7%, according to InsiderMonkey.com.
But the truth is, the majority of hedge funds posted pretty dismal returns, due to management fees, as well as enormously high turnovers, which just add more expenses. According to AR Magazine, 11 of the 25 top-earning hedge fund managers had single-digit returns last year.
Those returns, as well as investors looking for better risk management and quality investments, have caused constant outflows in the hedge fund business. But since assets obviously are expanding, that means other investors still are being swept along on the old hype of fabulous returns.
In truth, there are more than 21,000 hedge funds for which Morningstar has at least 300 data points. And they routinely follow some 11,000 funds that are part of their database. But also noting that they have data on more than 10,000 “dead” funds, you can easily see the tremendous comings and goings in the industry.
That means investor beware! Especially since banks are beginning to offer hedge fund like investments to less well-heeled investors now. Credit Suisse Group AG (NYSE:CS) just launched the Credit Suisse Liquid Alternative Fund (MUTF:CSQAX), with the intent of acting like a hedge fund, but with a minimum investment of $2,500.
Unfortunately, unwary investors will fight to be first in line at some of these “alternative” investments. But I say, “don’t believe all the hype!” There are much better investments out there.
In my next article, I’ll show you how to mimic some of the best hedge funds by structuring your personal portfolio — and without the astronomical fees.
As of this writing, Nancy Zambell did not hold a position in any of the aforementioned securities.