Hedge funds: There’s no free lunch

Ever since the big bear market of 2000-02, individual investors have been leery of the stock market. Still reeling from big losses and battered by scary headlines about the dollar’s decline, rising interest rates, and trade and budget deficits, they have flocked to “alternative” investments that promise big returns not tied to the stock market. Hedge funds have been the big beneficiaries. These lightly regulated investment pools engage in a variety of strategies from currency speculation to shorting stocks to other forms of speculation. They promise to make money in both up and down markets.

The reality may be a little different than the promise. Reports in recent weeks of hedge funds closing due to poor returns and lack of investment opportunities illustrates that there is no risk-free lunch when investing. In mid-June a $1.7 billion hedge fund, Marin Capital Partners, announced it would close and return its investors’ money. Marin said it was closing “due to a lack of suitable investment opportunities in the current market environment, and in our view an unfavorable risk/reward situation in the relative value strategies we trade.” The translation is as follows: “We can’t make money in this market.”

Marin is not alone. Less than a week after its announcement, another hedge fund, Bailey Coates Asset Management, said it had lost 25% of its investors’ money this year and would close. The London-based company said it had made bad bets on U.S. and European stocks. The fund managed $1.3 billion at its height, but it was worth only $500 million when the announcement was made. On the same day a third hedge fund, Aman Capital Management of Singapore, said it was returning $240 million to its investors.

Their experiences are not unique this year. The Wall Street Journal reported in its story on Marin Capital’s closing: “Many of the biggest, best-known funds have done a poor job, whatever the market, whatever the strategy. Even strategies aimed at limiting volatility have produced big losses this year.” It also reported that two of the largest hedge fund companies, Vega Asset Management and GLG Partners “are nursing big losses at funds they manage.”

This hasn’t stopped the big brokerage houses from pushing hedge funds to middle-class investors. Many now offer “funds of hedge funds” that allow investors with modest amounts to buy a pool of hedge funds. Whether they are buying something that will give them decent returns with low volatility is another story.

First, they face a big expense drag. The average hedge fund operates by the “two-and-20” rule, charging a 2% annual fee on assets under management and keeping 20% of any profits earned. Compare that to an average stock mutual fund, whose expense charge hovers around 1%, or to an indexed fund with expenses of 0.2% or less.

Second, they rely on the unproven claim that their particular hedge fund manager has a unique strategy and the skills necessary to implement it so that he or she can earn money even when others are losing it. On average, they don’t seem to excel. DFSB-Tremont, which publishes hedge fund returns, estimates that the average hedge fund gained just 3% in 2003 and 8% in 2004. The stock market—and the average stock mutual fund—handily beat those returns.

In the end, simpler may be better. A portfolio of diversified, low-cost mutual funds is a better bet for long-term profits with lower volatility.