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Originally published:
18 June 2006
Original link:
http://www.baltimoresun.com/business/yourmoney/bal-ym.jaffe18jun18,0,5607668.story
Real life doesn't always live up to our expectations.
It might be the "dream job" that comes with unforeseen nightmares, or the
fabulous vacation spot that leaves some visitors surprisingly nonplussed,
or the big lifetime celebration -- like a wedding -- that is remembered
more for big bills or family fights than for the love and joy of the
moment.
In investing, the security atop many wish lists is a hedge fund, a private
investment pool that is the domain of big institutions and people the
financial-planning community describes as "high net-worth investors."
For everyone aspiring to be a high net-worth investor -- and who doesn't?
-- hedge funds are sometimes seen as a sign that you have "made it."
But hedge funds may be another case where true life doesn't always live up
to the hype, and a new study from a San Francisco wealth management firm
suggests that most hedge-fund investors are not getting a performance
boost by going the exclusive route. Investors may dream of buying a hedge
fund run by a legend like George Soros, but they are much more likely to
get something far more pedestrian and disappointing.
For fund investors, the lesson is that you're probably better off managing
your money conventionally than pining -- or paying an adviser -- to
overhaul your portfolio to "invest the way the rich do."
To see why that is, let's consider how hedge funds work and then maybe why
they don't always work for an investor.
Hedge funds are unregulated investment vehicles. Like ordinary mutual
funds, they can have an investment objective and style, but unlike most
open-end funds, they can also take complex investment strategies designed
to profit in all market conditions.
Hedge funds are available only to qualified investors, effectively people
or institutions with a large chunk of money that they can pour into a fund
whose holdings they will know very little about. That small group of
investors can't get its money back on a whim -- withdrawals are allowed
only at certain intervals and the window is small -- but it can decide to
close down a fund if it doesn't believe management is doing well.
Management, meanwhile, typically gets paid a flat fee of 1 percent, plus
20 percent of any profits. That kind of payday attracts a lot of money
managers, but not all of them are good; those costs kill investors in
mediocre hedge funds.
"It's not that hedge funds are bad," says Jeff Spears, managing director
of Presidio Wealth Management in San Francisco. "It's that most don't
measure up, and the person getting into hedge funds for the first time
isn't going to get into the few funds that really have proven that they
can get the job done."
Presidio recently completed a research report that compared the
performance of a diversified investment portfolio to the Hedge Fund
Research Fund of Funds Composite Index, the industry benchmark for hedge
fund-of-funds. Typically, individual investors use a fund-of-funds when
they first go into hedge funds because it diversifies the risks.
From April 2000 -- the height of the bull market -- through March 2006,
Presidio found that the diversified portfolio (40 percent taxable bonds,
20 percent large-cap domestic stocks, 10 percent high-yield bonds, 15
percent international equity, 10 percent domestic small-cap stocks and 5
percent emerging markets) generated an average annualized return of 6.2
percent. The hedge fund index gained 5.2 percent.
Billions of dollars poured into hedge funds during that period, in large
measure because investment advisers felt hedge funds would give superior
bear-market results.
Not only did hedge funds lag during the down period, but over the longer
haul. Since 1990, when the hedge fund index was started, Presidio showed
that the diversified portfolio delivered 10.6 percent annually, compared
with 10.1 percent for the hedge funds.
"Hedge-fund managers talk about the benefits of lower volatility, better
diversification and superior performance a hedge fund gives your overall
portfolio, but that's not what most hedge funds are delivering," says
Spears. "But you can get all of those things -- plus full transparency and
everyday liquidity -- just by sticking with regular mutual funds."
Jerry Miccolis of Brinton Eaton Associates, a wealth-management firm in
Morristown, N.J., recently came to a similar conclusion. His firm was set
to recommend hedge funds to wealthy investors until its own research
showed there wasn't a compelling reason to make the change.
"The eye-opening thing [about the firm's research] was that when we
calculated what we'd be giving up if we didn't go into hedge funds, the
answer was that we wouldn't be giving up anything," Miccolis says. "So
while we understand why someone might want hedge funds, we're asking
'What's the point?' "
For most investors, Spears suggests that there will be no point to hedge
funds.
"If they have gotten to where they can afford a hedge fund without ever
having one, there is probably no reason to dramatically change what
they're doing," says Spears.
jaffe@marketwatch.com
Charles Jaffe writes for MarketWatch. He can be reached by mail at Box 70,
Cohasset, Mass. 02025-0070.
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