9 Simple Truths About Hedge Funds
Cloaked in secrecy, hedge funds operate outside the box and without government regulation. Be sure you know what you're getting before you take the leap.
By David Landis, Contributing Editor
From Kiplinger's Personal Finance magazine, March 2005
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Hedge funds are costly.
The average expense ratio for diversified U.S. stock funds is 1.5% per year. Hedge fund expenses are in the same ballpark, ranging from 1% to 2%. Where they diverge is in hedge funds' addition of a performance fee -- typically 20% of the profits they generate above a high-water mark. What's a high-water mark? If a hedge fund generates returns of 20% one year and loses it all the next, it means you won't pay incentive fees until the fund regains the ground it lost and surpasses its old high point.
Although this incentive system rewards fund managers for consistent performance, it's a steep price to pay. Say a fund earns 1% a month for 12 months, which compounds to just under 13%. If the fund charges 2% per year for management and a 20% incentive fee, you're left with just 8% that year.
Hedge funds come with a lot of restrictions.
Hedge fund managers want the freedom to pursue complex or long-term strategies without worrying that shareholders will take out their money. An initial one-year commitment is a common requirement. Once it is fulfilled, you still may be able to reclaim your money only once per quarter, or perhaps monthly. Some managers place a cap on periodic outflows. So if a lot of investors want out at once, it may take several quarters to unload your stake.
And don't expect detailed quarterly reports of hedge fund holdings. Hedge funds aren't required to provide them (although some do). Some hedge funds will disclose only the barest of details about their portfolios for fear of tipping their hand to rivals. It can be tough to know whether the manager is sticking to the strategy you bought into.
Hedge funds have often gotten into trouble over the years.
The combination of risky strategies, large sums of money and lack of oversight can create spectacular blowups when things go wrong. Case in point: Long-Term Capital Management, a hedge fund whose founders included two Nobel laureates. Through a staggering amount of borrowing, it turned $4.8 billion in partner equity into $125 billion in assets. When its complex strategies failed in the summer of 1998, its investors lost 92% of their capital. Less dramatic failures occur from time to time. There have also been 51 cases of alleged fraud in the past five years, says Paul Roye, chief fund regulator at the Securities and Exchange Commission. Investor losses in those cases totaled $1.1 billion. In addition, more than 400 hedge funds were involved in the mutual fund late- and rapid-trading scandal. "All too often, hedge funds were the late traders and abusive market timers," says Roye.
Hedge funds bite the dust frequently.
A key reason for the high attrition rate of hedge funds is the high-water-mark fee arrangement. If a fund loses money, it can't collect its incentive fee until it recovers. That can lead talented staffers to bolt for other funds that are still on the incentive-fee gravy train. It can also lead fund managers who are in the red at midyear to take extraordinary risks in the second half to get back above water. If the gamble fails, the manager may simply decide to return the capital to investors and start over with a new fund. According to Malkiel and Saha, 10% to 18% of hedge funds disappeared each year from 1994 through 2003. Given that hedge funds are pitched as a way to reduce risk, these numbers aren't comforting.
--Research: Jessica Anderson