Hedge Funds: You Name It, They Trade It

Note from Knight Kiplinger: Hedge funds are coming under fire, with recent articles in The Washington Post and BloombergBusinessweek. In this column written six years ago, when hedge funds were flying high, I laid out what I didn't like about them on principle: their lack of transparency, liquidity and government regulation, plus their high management fees. I still feel the same.

You should give your money only to investment managers who can clearly explain their investment strategy, who will give you back your money whenever you need it, who are subject to regulatory oversight, and who charge reasonable fees. And never put all your money in a single investment fund, even a mutual fund from a respected fund family. The bottom line: Know what you're investing in, spread your money over several asset classes (stocks, bonds, real estate, etc.), and use numerous money managers and index funds.

Read our Fund Watch column: Are Hedge Funds Right for You?

The other day I spoke with a money manager who wanted me to invest with his firm. I had a lot of questions.

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What do you invest in? I asked.

"Anything that we think is poised for a gain at any particular moment," he replied.

Such as?

"U.S. and foreign stocks and bonds, currencies, petroleum and metals futures, office buildings, start-up ventures, private companies, mortgages, shares of companies about to go public. You name it, we trade it."

How will I know which kinds of assets my money is in at any given moment?

"You won't. Our clients trust us to move their money in and out of all kinds of assets rapidly, and there isn't time to tell you in advance."

What trading techniques do you use?

"Any and all that we deem suitable to the circumstances: buying on margin, short selling, derivatives -- whatever."

Can I withdraw my investment on short notice?

"Actually, no. It would hamper our performance to offer instant liquidity to our investors. But after we've had your money for one year, you can usually withdraw it once a quarter or so, depending on market conditions."

What's the minimum investment for opening an account?

"We originally required at least $1 million, but we're pleased to announce a new program for the smaller investor, with an opening minimum of just $100,000."

What's the annual cost of your services?

"We charge you 2% of your account value each year, and we keep 20% of your investment gains."

Isn't that a little steep? After all, hot-shot mutual fund managers like Bill Miller at Legg Mason and Ken Heebner at CGM charge just 2% or less each year and there's no "incentive fee," so I keep almost 100% of my gains.

"Sure, they've done a great job of beating the big indexes year after year, but our firm is doing far better for our clients, even after we take our 20% off the top."

Can you send me some audited performance data going back, say, five years?

"Well, we started our company two years ago, and performance varies a bit from account to account. But our managers have great records from their previous jobs."

Is your fund registered with, or regulated by, any government agency or industry watchdog?

"Not at present, but I hear there's some talk about future oversight by the Securities and Exchange Commission."

Hedgehogs

If you haven't guessed by now, this pitch was from a hedge fund -- and I took a pass. The answers to my questions revealed what I don't like about their style of investing.

To summarize: Hedge funds are unregulated pools of capital that may trade in any asset class, with any methods they wish and without telling clients in advance how they plan to invest the money. They charge high fees and offer limited liquidity.

The pioneers of hedge funds included quite a few brilliant investors, and their returns were often eye-popping, as they darted in and out of undervalued assets all over the globe. But just as adding teams to Major League Baseball dilutes the average quality of pitchers, the proliferation of hedge funds has strained the supply of investment talent.

Not-so-spectacular

With hedge-fund managers often overpaying for the same foreign stocks, private-equity deals and initial public offerings, it's not surprising that average hedge-fund returns are coming down to earth -- and will likely flatten further.

But as competition for capital intensifies, so will the pressure to produce dazzling returns. Chasing big rewards always requires taking big risks -- with the potential for big losses.So when it comes to hedge funds, I'll just say no.