In popular culture, hedge funds often get portrayed as the Holy Grail of investing. They are these secretive, exclusive, and not-well-understood entities that can invest better than anyone or anything else. If you invest in a hedge fund, you are on the inside. And if you invest in a hedge fund, you get incredible returns. Returns that just aren’t available to the average investor. At least that’s what it seems like. But is it really? What does the data say? Because it actually turns out, there are some pretty big problems with hedge funds.
So let’s look a little bit deeper…
What are hedge funds?
Seems like a silly question because pretty much all of us have heard of a hedge fund. But honestly, I couldn’t give you a definition as of a couple days ago.
Basically, hedge funds are composed of pooled money from many private investors. They are generally managed by an active manager. And they use more risky and complex investing strategies – like using leverage to investing in non-traditional assets – all with the goal of achieving higher than usual returns.
Never mind that they also generally carry much higher fees and minimum investment limits.
But the important thing to understand here is that, at their core, hedge funds are designed to improve returns.
So they are pretty much pointless is they cannot do this.
Do hedge funds improve returns?
Well, thankfully, tons of studies have examined this very question.
Here are some of them:
- A 1999 academic study found that most hedge funds underperformed the S&P 500 index
- Also in 1999, a Forbes article examined the performance index of 2,600 domestic and international hedge funds from 1993 to 1998. The author found that the average annualized return of these funds was 13.4% after fees. This trailed the returns of the S&P 500 index over that time frame by 6.5%
- In 2006, another academic study found that, from 1995 to 2006, the average hedge fund underperformed the S&P 500 index by 2.6% annually. (Also note this time frame included a big bear market. A purported advantage of hedge funds is that they perform better in down markets…)
- In a 2001 academic study, authors studied 13 hedge funds finding that 92% showed no additional risk-adjusted returns
- A 2003 study looked at hedge funds from 1994 to 2001 finding that the average fund of hedge funds underperformed an equally weighted portfolio of randomly selected hedge funds by 3% each year. Thus, you’d do better by picking a random hedge fund
Overall, this evidence contradicts the claim that hedge funds offer higher than average risk-adjusted returns. Further, there is no evidence of the ability of any hedge fund to over-perform beyond what is expected by chance.
That’s two big strikes against something whose sole purpose is to offer greater than average returns!
That is bad enough. Basically that’s the same problem that plagues actively managed mutual funds. More risk and more cost for subpar results.
7 big problems with hedge funds
However, there are even more problems with hedge funds!
1. No liquidity
Hedge fund have long lock up periods. And the ability to withdraw funds can even be suspended by the manager. And as we see, there is no additional return rewarded for this risk.
2. No transparency
Hedge funds don’t even have to disclose how they are investing your money. That’s a huge risk. Especially when one of the most important tenets of your financial plan is your asset allocation! In a hedge fund, you give that up.
3. Bad distribution of returns
When you look at hedge funds, they have non-normal distortions of return. They have negative skewness meaning that most hedge funds lose, but losses are small (although big losses happen at a greater that usual frequency) and a few winners win big. This is the same distribution that lottery tickets exhibit. And you wouldn’t invest in lottery tickets…
4. They die
Sounds dramatic but that’s exactly what they do. A 2005 study by Burton Malkiel, one of my favorite economics writers, found that less than 25% of hedge funds in existence in 1996 were still functioning in 2004.
Moreover, the positive upwards bias on returns that could be attributed to this survivorship bias was 4.4% per year. This means that returns for hedge funds were actually over estimated by 4.4% each year! In fact, there is even other bias called backfill bias and liquidation bias due to self selection (poorly performing or liquidated funds choose not to report) that is responsible for another positive 5% bias each year. for hedge funds.
Another study found that the median lifetime of a hedge fund is just 5.5 years. That’s not good when we are investing for the long term with a goal of financial freedom.
5. They are risky
Hedge funds use leverage and invest in illiquid assets as we’ve discussed. This results in greater risk. However, in most cases, hedge funds and even studies of them use less risky benchmarks as their comparison. This is dec living because on a risk adjusted basis, hedge funds actually perform even worse!
6. Very tax inefficient
Hedge funds have massive turnover. This means more tax implications in addition to the higher fees.
Most doctors I know are trying to reduce their tax burden. Hedge funds won’t do that. And the sub-par returns are no consolation for these higher taxes.
7. The house always win
There is serious risk that we need to discuss called agency risk.
So, most hedge fund managers are rewarded by incentive pay in the form of 20% of profits. Agency risk shows up in a hedge fund when, towards the end of the year, a manager fails to reach or exceed their goal returns. The manager is incentivized to take more risk to boost returns. If they succeed, they get a bonus. If they don’t then they still receive the minimum pay.
They always win. You probably lose.
These are big problems, especially for doctors
As physicians, we earn a high income. We are more fortunate than most in this regard. As a result of our income, our recipe for financial freedom is pretty simple:
- Save at least 20% of our gross income and
- Invest that money wisely
And, again because of our large income, we can adjust our savings to create a bigger margin between what we earn and what we spend if we need to accelerate our path to financial freedom.
The one thing we especially don’t need to do is to take on excess risk. Returns are a big part of what will grow our nest egg to retirement. But an even bigger part of the equation, especially when we start, is the savings.
By taking on excess risk in our investments, we actually decrease our returns (see data above) and increase our risk of not becoming financial independent. As a result, burnout ensues, we suffer, our patients suffer, and the field of medicine suffers.
All that glitters is not gold
Hedge funds, like active investing in general, are built on the whimsical notion that it is possible to beat the overall stock market.
Unfortunately that is just not possible.
Someone may beat it today. But they are no more likely to do so in the future than dumb luck would dictate. In fact, today’s losers are more likely to win tomorrow than today’s winners are.
Avoid the static. Ignore the noise. Stick to sound investing principles.
Here are some more great posts discussing these very same sound investing principles:
- Our Complete, Updated 2024 Written Financial Plan
- The Best Stock Market Explanation I Have Ever Heard
- 5 Undeniable Ways That 1% Returns Will Make You Wealthy
- 5 Reasons Index Fund Investing is Better the Stock Picking
What do you think? Have you invested in a hedge fund? How did it go? What problems have you seen with hedge funds? Would you ever consider investing in one? Let me know in the comments below!
