| 04 September 2007
Virtually every industry periodical that I read has an article about alternative investments. These are things other than stocks, bonds, mutual funds and other mainstream investments. Examples of alternative investments would be direct real estate ownership, oil and natural gas interests, private equity, venture capital and commodities to name a few - but the one garnering the most attention lately is hedge funds.
The original premise behind hedge funds was to employ strategies that would provide a positive return in all types of markets. Many purport to manage risk. In reality, there are thousands of hedge funds – even more than mutual funds - and they employ a wide variety of strategies. Many involve leveraging and other speculative investment practices that can increase the risk of investment loss.
In fact, Long-term Capital Management became infamous in 1998 when the multi-billion dollar hedge fund imploded and nearly reeked havoc in the broader financial markets. Long-Term Capital was operated by two Nobel prize-winning economists. If they couldn’t control the risk and deliver the results advertised, what does that say about the countless other hedge funds out there?
Hedge funds are similar to mutual funds in that they are pools of money with a manager hired to make the investment decisions for the owners. Unlike mutual funds, though, they are not highly regulated – at least not yet. Regulators are taking a closer look at them as they grow in popularity.
If they are so popular, why don’t we know more abut them? For one thing, they have traditionally only been available to accredited investors with large amounts of money to commit. Regulators have figured that institutions and high-net worth individuals are more sophisticated and don’t need as much protection, so hedge funds are not required to operate under the same rules as mutual funds. Hedge fund investors really aren’t necessarily more sophisticated – to paraphrase a famous quote - they just have more money than most of us! These funds do carry a certain panache, though, which makes them popular with the high net worth crowd.
Compared to mutual funds, hedge funds can hold more concentrated positions (less diversification) and more illiquid investments. They also have ridiculously high fees – often charging 1% to 2% of the asset value plus a performance fee of 20% of hedge fund profits. Is it any wonder that so many successful mutual fund managers have bolted to run hedge funds?
So what’s wrong with the hedge fund manager sharing in the gain if it makes money for the investors? For one thing, it’s not necessarily their brilliance creating the gains. It is your money – or capital – that is generating the return. The capital markets will generate an appropriate gain if invested prudently – and there is no evidence to show that hedge funds deliver above market returns after adjusting for risk and expenses.
Secondly, with such a strong incentive to show an oversize profit, hedge fund managers are induced to take excessive risk. What have they got to lose, it’s your money not theirs. It’s sort of like heads, I win – tails, you lose!
You should never invest in something that you don’t understand, and lack of disclosure and transparency is another problem with these funds. I want to know what my fund owns and its strategy. There is plenty of timely information available about regular mutual funds. For detailed information about a no-load mutual fund, you can easily obtain a prospectus. Easier still, you can use a rating service such as Morningstar which does the work for you.
These alternative investments have proliferated to encompass a much wider group of candidates. There are even mutual funds that invest in hedge funds thereby making them more accessible. They have similar benefits (if there are any) and disadvantages as regular hedge funds but they come with a second layer of fees – adding insult to injury.
So, are the rest of us really missing out on something? Should we be looking at alternative investments? I don’t think so. The better strategy is to stick with fundamentally sound investments that are easily understood and have a proven track record.
Successful investing is really quite simple – diversify using low-cost mutual funds using an asset allocation suitable to your personal risk preference and keep your investment expenses and taxes as low as possible. Follow this simple formula and you will be successful - and you won’t need alternative investments.
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