Hedge Funds: A Luxury Nobody Can Afford

I recently read a piece by Jim Parker, a Vice President at Dimensional Fund Advisors, entitled “Hedge of Darkness.” Parker notes, “Big money can be made from hedge funds. If you run one, that is.” Parker goes on to offer some amazingly compelling statistics from The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to be True by Simon Lack, an asset manager who once chose hedge funds for JPMorgan.

For example, Lack begins his book with the statement, “If all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good.” Other potential surprises noted by Lack: The 18% return on hedge funds in the nine years to November 2011 was easily beaten by the total 29% gain from the S&P 500 index. The gap was even more pronounced for investment grade corporate bonds, which in the same period gained 77%, as measured by the Dow Jones Corporate bond index.

Of course, I’d emphasize Lack’s point that the underperformance of hedge funds over this period is even greater once the 2% management fee and 20% performance fees charged by hedge fund managers are factored in. In fact, Lack estimates that from 1998 to 2010, the hedge fund industry captured at least 86% of the returns it earned for its customers. So while hedge fund managers amassed great fortunes, their investors earned subpar returns.

In addition to the high fees that eat into returns, poor disclosure, complex legal structures, and the great number of fraud cases contribute to hedge fund’s risk/reward ratio being way out of whack. Pull the lavish curtain aside and what’s advertised like an exclusive five-star resort often turns out to be a dumpy roadside motel.