The problem with investing in Hedge funds
The only way you can know if your investments are suitable is if you understand what you are actually investing in.
A key question to ask yourself about your existing investments is the following.
Can you simply articulate what you actually own and why you do so?
If you’re unable to do this, how do you know if your investment is appropriate?
The financial environment can be incredibly complex and is filled with choice. Some of this choice is good, such as being able to access global investments, literally at a click of a mouse.
However many of these complications appear solely designed to extract large fees from you without providing the corresponding value.
As an example, let’s take a look at a prominent investment structure that isn’t particularly transparent or simple – Hedge Funds.
What is a hedge fund?
The phrase ‘hedge fund’ can be misleading, in that hedging has been around for a long time, but it’s not exactly what hedge funds do.
What makes a hedge fund different from a plain vanilla mutual fund?
Well, a stock mutual fund will simply buy and sell (but hopefully hold for a long time) shares for it’s investors. They gain if prices rise and when they receive dividends, but lose if the prices fall. So we could call this a long only strategy.
A hedge fund will use tactics such as short selling, leverage and derivatives to attempt to generate uncorrelated and larger returns than the market can provide.
Hedge Funds traditionally charges a variation of 2% each year, plus 20% of any returns above a certain level.
Some hedge funds provide amazing returns in any market to justify these incredibly large fees, however many firms have jumped on this trend. In the US alone, there are now approximately 10,000 funds operating some form of hedge fund, yet go back to the 1970s and 80s and there were only a handful, operated by what can only be described as financial geniuses.
Do you really think there are now 10,000 financial geniuses? Or will the majority of these funds disappoint, while taking a huge portion of investors wealth in the process through high fees?
Which hedge fund would you invest in?
There is no doubt there are a few financial geniuses out there who can compound your capital at incredible rates each and every year. But finding these geniuses using foresight, rather than hindsight, is incredibly difficult.
Take a look at these hedge fund investment options.
Hedge fund manager A is a founder and chairman of an investment firm. He has decades of experience. His firm helped create the technology for a major US stock exchange and he was formally a non-executive chairman of this famous exchange. He has served as Chairman of the Board of Directors and on the Board of Governors of the National Association of Securities Dealers. He served on the Board of Directors of the Securities Industry Association and was the founding member of the London International Securities Clearing Corporation.
His fund is a popular fund, attracting capital from many leading financial institutions and charities. His funds attracted between $36billion- $57billion of capital and provides consistent and attractive returns, despite the direction of the stock market.
Hedge fund manager B struggled to gain entry to the financial world and gained his first employment at a merchant bank, largely because the managing director was a fellow Hungarian.
His philosophical studies led him to develop a theory that was very different from theories that have been popular with prominent financial firms and leading universities for the past decades.
In 1970 he founded a fund with only approximately $12million in capital and was registered in Curacao, Dutch Antilles, at the time a small infamous tax haven.
The fund charged a percentage each year, plus 20% on the profits. This was a relatively new and expensive charging model.
So which hedge fund would you invest in?
I expect many people would feel comfortable investing in Fund A and wouldn’t touch Fund B.
However, the correct investment to make is hedge fund B.
These are selective facts* about two very famous financial operators. Some of you may well know who these people are.
Hedge Fund A was operated by none other than Bernie Madoff. He operated the largest Ponzi scheme in history and is now imprisoned. Many of his victims were left significantly out of pocket by his thievery.
Hedge Fund B was operated by financial genius George Soros. He was perhaps the most successful hedge fund manager in the world, famously made $1billion in a single trade betting against the Bank of England in 1992 and is now one of the world’s richest people. His returns to investors, spanning several decades, were approximately 20% pa compounded.
*I’ve purposely taken selective information from Wikipedia to come up with these options to provide this valuable lesson.
Conclusion
When something is complicated and opaque, it’s harder to select the right choice. You can achieve all of your goals by selecting simple and transparent investments.
It would therefore be unwise to chase higher returns in more complex structures and strategies.
If you do this, you just might end up losing your shirt.
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