Financial Fads—Hedge Funds Anyone?

Financial Fads--Hedge Funds Anyone 05 13 2014Fads are nothing new—they come and they go. We’re drawn to THE new trendy and hot restaurant, bar, travel destination, fashion—whatever is of the moment. And this extends to the right place to invest our money.

Financial fads have included tech stocks, newly emerging markets, gold and commodities—and now the topic du jour is “alternative investments”, i.e. hedge funds. It all sounds so mysterious and sexy and those promoting this methodology make sure to keep the aura alive. Let’s face it, there is an allure to being “in”, or at least feeling in.

Financial fads aren’t going away. They are usually manufactured by those who live by the mantra: if you build a better mouse trap, we will just build a better mouse. The typical outcome is that some people do really well, many get hurt, and the manufacturers make a lot of money and—eventually—wind up paying fines for building mice that ate someone else’s cheese.

Need a reminder of how financial fads played out? Think junk bond scandals, tax shelter schemes providing investors with huge leverage write offs and derivative investments that made credit easier than turning on the water in your sink.

Hedge funds are just the latest financial fad. Unfortunately, investors are mostly unaware of the dangers lurking in the shadows. Here are a few of them to consider:

1.  The industry is largely unregulated.

2.  There is little or no transparency.

3.  Costs are significant—2% on assets and 20% of profits.

4.  Performance numbers are inflated by “survivorship and other bias”.

5.  They cover a confusingly wide range of strategies.

On April 30, 2014, SEC Chairman Mary Jo White said that hedge fund and private equity fund managers have been charging improper fees to portfolio companies or the funds they manage.  Additionally, the SEC’s Office of Compliance Inspections and Examinations (OCIE) has issued a 10-page Risk Alert on the due diligence process that investment advisers use in recommending alternative investments (hedge funds, private equity funds, etc). OCIE Director Drew Bolen said, “Money continues to flow into alternative investments. We thought it was important to assess advisers’ due diligence processes and to promote compliance with existing legal requirements, including the duty to ensure that such investments or recommendations are consistent with client objectives.”

Impressive historical returns are often touted as an attractive hedge fund feature. Well, who wouldn’t get excited by big number performance? However, there are several biases in these reported returns. There is non-reporting bias—since hedge funds have the option not to report their performance. And survivorship bias eliminates all hedge funds that have tanked and disappeared. How can an investor be properly informed in the presence of these two elements?

In addition there are some other “eccentricities” that potentially can mislead investors, such as the instant-history bias where a manager may begin multiple hedge funds, each one based on a different strategy, with a small amount of the seed money in each. After a couple of years, the successful strategies will go public and their historical records are made public. The records of the unsuccessful strategies are not made public. On top of all that, the historical returns earned by the successful strategies are not returns earned by typical investors.

There are many different strategies covered in the spectrum of hedge funds.  Knowing which strategy is best for you, your risk tolerance, time horizon and overall investment goals matter greatly. For example, there are:

1.Long-Short Funds: Take both long and short positions in securities in hopes of using superior stock picking strategies to outperform the general market.

2.Market-Neutral Funds: A sub-type of a long-short fund, however fund managers attempt to hedge against general market movements (thus the name “market neutral”).

3.Event-Driven Funds: An attempt to capture gains from market events, such as mergers, natural disasters or political turmoil.

4.Macro Funds: Take directional bets on the market as a whole, either long or short, based upon research and/or the fund’s philosophy.

Are hedge funds just another fad? If the government decides to actually protect the consumer, greater regulation might remove some of the fake sexy as the true facts and realities become apparent. Unfortunately, I wouldn’t bet on it—those who benefit most from these unregulated investments have buckets of money to sway politicians to look the other way.

If you want to play with a fad, don’t play in the hedge funds’ current sandbox—go get yourself a hula-hoop.

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