Hedge Funds Steal Profits

On the list of the most dastardly, soulless, evil people to ever exist, there are a few regular front-runners.

Adolph Hitler, Idi Amin, and Pol Pot come to mind for me.

And then, right behind those guys, there are hedge fund managers.

Okay, that might be a slightly dramatic comparison — but just a slight one, and I’m sure there are people out there who share my sentiments.

Even if hedge fund managers had hearts of gold, the basic model of hedge fund operations makes it very unlikely that investors will experience genuine, full profits.

Before I get to why I (and others) feel this way, let’s do a quick review.

What Are Hedge Funds?

Like ETFs and mutual funds, hedge funds are another method of using pooled funds to garner alpha returns for investors.

The difference is the flexibility and variety of strategies available to hedge funds. Some are short-term and event-driven, others are long-term and macro, depending on the style of the firm and its managers.

Currently, the largest hedge fund firms are Bridgewater Associates, J.P. Morgan Asset Management, Brevan Howard Asset Management, and Och-Ziff Capital Management Group.

These are just a handful of the 11,000 hedge funds that are managing close to $2.6 trillion in the United States.

Individual managers make millions of dollars per year and millions of rapid trades per day.

President Obama called them “society’s lottery winners.”

Up until very recently, hedge fund clients were limited to the very select upper echelon of investors.

These are wealthy clients with a net worth of at least $1 million, but usually more. We call them “sophisticated investors.”

SEC regulation is basically non-existent for these guys, and the investments remain a mystery even to the investors.

(In fact, most hedge fund investors don’t even know where their money is going. They just receive a monthly report outlining their fund’s overall performance.)

The SEC basically believes that if you are a person with that much money, you also have some level of investment savvy.

So they will essentially allow you and your hedge fund manager to play with (and possibly lose) that money however you like — as long as it’s legal.

This isn’t a piece about blatantly illegal scamming… if it was, it would be two words long:

Bernie Madoff.

Unfortunately for investors, there are legal practices performed by hedge funds that still make them completely undesirable.

How?

The short answer here is that hedge fund managers essentially steal money from their clients with every trade.

They do it through fees.

Exclusive status as a “sophisticated investor” comes with a price: “two and twenty.” The hedge funds pay themselves 2% of all the assets they oversee and 20% of any gains over the year.

With fees like that, you’d probably expect to see significant returns on your “sophisticated” investments.

If profits are flowing, then “two and twenty” isn’t so bad, and everyone is making money.

Unfortunately, based on a variety of measures, hedge fund performance is average at best.

Earlier this year, experts at Goldman Sachs announced, “Hedge funds are on pace to lag the market index for the seventh straight year.”

In every year since 2002 — even during recession and plateau years — the typical 60/40 portfolio outperformed the average hedge fund.

Between 1994 and 2011, hedge funds generated an annual return of 6.5%. That’s about the same as the stock market and less than bonds, which generated 7.2% returns.

In the last five years, the stock market has done nothing but go up, while hedge funds remained mediocre with returns of 4.8% per year compared to the S&P 500’s 14.3%.

But we haven’t considered the fees. Remember, “two and twenty.”

So we need to hand over 2% for those handling fees. These are universal, no matter the outcome of your investment.

Then take away 20% of any gains. (Most hedge funds try to show a little humanity and good faith and won’t charge an extra incentive fee unless returns exceed 5%.)

Either way, that 6.5% has been knocked down to a fraction.

And that’s if you generate any profit at all.

No matter how you look at it, the numbers are clear: Hedge funds do not outperform the stock market.

However, hedge fund managers are outperforming you.

“Hedge funds have taken 84% of net real investor profits since 1998. Funds of funds have taken 14%, and only 2% has gone to investors.” — Simon Lack, former JP Morgan hedge fund manager

These “bad boys of finance” still make their buck even if you are in the red.

After the 1990s, the number of hedge fund firms grew immensely, especially as people noticed the exorbitant amount of money in managers’ pockets.

To achieve a further reach and gain a competitive edge, some funds began loosening the requirements for investment.

Rather than require high-profile clients with a net worth in the millions, investors with just several thousand can now throw their money into the murky, mysterious waters.

In the face of growing criticism regarding their fee structure, many hedge funds have altered the “two and twenty” model.

But the fact remains that hedge funding is the only field of work where employees are compensated even for poor performance, and their clients are footing the bill.

The entire industry is designed to filter money back into the hedge fund.

All things considered, we are forced to ask…

Why are investors still participating in hedge funds? Why would anyone pay more for less?

Theories abound. There are studies of human activity and why certain trends become popular.

Some experts reduce this down to “investors are sheep,” saying that a herd mentality causes all of us to mindlessly follow each other without question.

Others compare hedge fund investments to buying a lottery ticket.

We can all probably understand the allure and thrill that comes with a gamble. (I’ll admit, I have a soft spot for scratch-offs.)

Put your money in hoping that more comes out.

However, hedge funds are slightly different.

These are complex financial institutions.

Sure, not all of them are inherently evil, and there might even be a few out there that can help you turn a profit.

But as hedge funds continue to compete for investors, we suggest that everyone maintain a skeptical eye.

Behind all the smoke and mirrors, that hedge fund might fall closer to a Ponzi scheme.

Remember: Their main goal is to make money for themselves. The system has been working for them for years, and I doubt they want to change it anytime soon.

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