One of the supposed benefits of investing in a Hedge Fund, is the opportunity to make money in both up and down markets. This goal is appealing to two types of investors. First, those who do not have the discipline to stick with a “buy and hold” strategy and secondly, it’s alluring to those who believe in “magic.”
With Hedge Funds, transparency is limited, but this lack of transparency is widely accepted by Hedge Fund investors. Perhaps it’s because it’s hard to believe in “magic” if the data shows that there is no “magic.” There is however, enough data to show that the collective performance of hedge funds over the past 10 years, falls short of market rates of return that are easily earned with index funds and other passive strategies.
The standard pricing structure of a Hedge Fund, that is 2% per annum, plus 20% of any gain, seems to be acceptable to those using Hedge Funds. Do the math: An investment of $1 billion in a Fund that earned 10% would yield a fee of $40 million. It’s absolutely ludicrous. But in spite of this fee structure, the Hedge Fund industry continues to grow, as does the wealth of the Hedge Fund managers. It is not unusual for a successful Hedge Fund manager to take home over a billion dollars in one year.
So are these Hedge Fund billionaires bad guys? Not really, there are just very good at moving other people’s money into their own pocket. And who are these “other people?” Hedge Fund investors fall into three groups: Wealthy individuals, Pension Plan sponsors, and those managing University Endowments.
It may be foolish to invest in Hedge Funds but wealthy investors can do whatever they like. After all, it is their money. But the last two, Pension Plan sponsors and Endowment committees, are managing “other peoples money.” The money in Pension Plans belongs to current and former employees, not those making investment decisions, and if Endowment Funds underperform, students and others will be asked to make up the difference.
My former colleague, Rex Sinquefield, once said that Hedge Funds are “Mutual Funds for stupid people.” That’s a bit harsh, but perhaps Pension Plan sponsors and members of the Investment Committee of Endowment Funds are not stupid, they just fail to understand and/or they refuse to accept the Fiduciary responsibility they have when investing other people’s money. It may not be their money but it must be quite an ego trip to have control over how the money is invested.