Three Great Reasons to Avoid Hedge Funds

For wealthy investors, hedge funds are as tantalizing as Apple’s new iPhone. Of course, millionaires don’t have to stand in a line that snakes around a city block to pick up shares in a hedge fund. And that’s part of the hedge fund’s powerful allure. Most people aren’t worth enough money to be able to invest in these funds. So there are no messy crowds.

Hedge funds are incredibly exclusive and, all I can say to that, is this: Thank goodness. The more investors who can’t qualify for these things, the better.

A couple of months ago, I spoke to two dozen women, who belonged to the Junior League, at a beautiful estate overlooking La Jolla Shores. I expected that somebody in the room would eventually ask about hedge funds and I wasn’t disappointed. They looked stunned, however, when I started explaining some ugly hedge fund truths.

For starters, the women had no idea that hedge fund managers are fee hogs. They commonly charge what’s called “two and 20.” The typical yearly investment fee is 2%, which is outrageous. But it’s far worse than that. If the hedge fund enjoys a profit, the managers pocket 20% of it. If the hedge fund loses money, the managers still collect 2%. For those who invest in a hedge fund of fund, the fees can be far worse. For the lucky hedge hog, it’s a “heads I win and tails you lose” scenario.

Hedge funds are also concealed inside black boxes. Managers don’t have to tell you what they are investing in, which is another serious strike against them. What’s more you can’t expect to pull out your money whenever you please. These things aren’t equippped with ATM cards. It could take months before you are permitted to withdraw your own cash.

Many people assume that hedge funds produce incredible returns because managers seem to live in opulent mansions that dot the manicured grounds of estates up and down Connecticut. But folks it’s often not their investing acumen that has blessed them with great wealth, it’s the proceeds from those stunningly high fees.

My favorite observation about hedge funds comes from Eugene Fama, a brilliant economics professor at the University of Chicago, who some expect will eventually win a Nobel Prize. I was attending an investing conference in Los Angeles in 2002 when someone asked him his opinion of hedge funds. Here was Fama’s response: If you want to invest in something where they steal your money and don’t tell you what they’re doing, be my guest.”

You will find a wonderful story about hedge funds in this week’s issue (July 2) of The New Yorker.

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