The Big Lie About Hedge Funds

By Brad Kemper

Hedge funds are really making the news. About half the news is bad, blaming hedge funds for everything from market sell-offs to global warming. The rest of the time the news is gushing about the fabulous returns that hedge fund investors are banking every month.

So whom should we believe? Well, I am pretty sure that hedge funds are not responsible for global warming but the surprising truth is that most investors are not doing any better investing in hedge funds than they would investing in the stock market. And probably a lot worse.

Hedge funds differ from mutual funds in that they restrict the type and number of investors that may participate. Approved investors must own at least $1 million in assets and have an income of at least $250,000 a year. Apparently the regulators believe that people who fall into this category are better educated and sophisticated enough to understand the risks they are taking. (Be glad you do not fall into this category)

By doing this, hedge funds do not have to follow the same regulations that mutual funds must adhere to. Hedge funds can charge higher fees and often use leverage and invest in derivative investments that mutual funds cannot use. Hedge funds also do not have to report results like mutual funds and so you will read only about the high flying funds while the losing funds are closed and quietly fade away. This little known fact causes the estimated returns of hedge funds to appear higher than they really are.

Hedge funds really only benefit the fund operator who charges a set annual fee of 2 to 4 percent plus a performance incentive of 20 to 40 percent of gains. George Soros, founder of the Quantum Fund in the late 1960's, one of the most successful hedge funds of all time, had a few good years and made some money for the original investors as well as for himself. Eventually the fund busted so bad that it had to be shut down. Most of the later investors lost all of their money, but how did Soros fair? An exact number is hard to determine because hedge funds are not required to divulge results but a New York Times article in 2004 estimated that Soros was worth more than $11 billion and that most of that money was attributed mainly to his management of the Quantum Fund. Not bad work if you can get it.

Hedge funds like most investment advice and management firms draw most of their revenue through fees. Most investors read the financial press or watch financial TV and believe that these professionals are earning their fees through exceptional performance. However, the facts just do not bear this out. In fact, the best money managers typically under perform the overall stock market by the amount they charge for management fees.

For this reason, average investors can and do out perform mutual funds over the long haul. Avoid the big lie about hedge funds and secure your financial future.

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