I have always been sort of fascinated by the shady world of hedge funds, and I had some idea of what they were, but I wasn’t clear on a lot of things. Lately I have been doing some reading on the topic (starting with The Little Book of Hedge Funds and then looking into a few of the author’s suggestions from there). A couple things I know for sure after reading thoughts and opinions from vaunted “industry insiders” is that:

1) I am not cut out for hedge fund investing, and I wouldn’t have enough money to invest in them for at least a decade even if I decided they were for me.

2) The relatively few people on the planet that can “beat the street” are almost assuredly in the hedge fund world (re: NOT mutual funds).

For those of you that don’t know much about hedge funds, I definitely won’t hold myself up as an authority on the topic, but the basic idea is a pool of capital that is exclusive to wealthy investors, and has very few rules and regulations as to what can be done with the capital at its disposal. Without throwing around too many overly technical terms and Greek letters, the theory behind the original hedge funds was that these pools of money would be able to “hedge” against their investments, or protect their downsides. This is different from the world of mutual funds where money managers are basically only allowed to “go long” and invest in stocks they believe will increase in value. Although those are the origins of hedge funds, the modern day versions span a huge range of structures and investment classes. The overall premise behind today’s hedge funds is that they can invest almost any way that they want with almost no oversight. If managers want to throw everything into derivatives they can, if they want to go to cash, or short European markets, they can do that too. The freedom that these money managers have is unparalleled in the industry.

“2 and 20”

If hedge fund managers are able to parlay this freedom into above-average returns (as a substantial number are) they get paid quite well. The industry standard has apparently been coined as, “2 and 20”. The numbers stand for 2% of assets up front, and 20% of profits generated. If that seems extreme, that’s because it is. Warren Buffett is actually on record as saying that due to this compensation model he is dubious of the whole idea that investors can make money in hedge funds over the long-term. Of course the old Oracle himself did run hedge funds early in his career, and now employs former hedge fund people as some of his top advisors, so you figure it out. The reality is that hedge fund managers make incredible amounts of money. If they have a modest-sized fund of $100 million, they would automatically make $2 million in a given year. If they matched the market in an average year and their portfolio rose 10%, they would take home 20% of the $10 million profit ($2 million). That’s for a fairly small hedge fund.

The Cream Rises To The Top

When I go through my usual sparring matches with mutual-fund devotees, one of the things I like to point out is that John Bogle (founder of Vanguard) and several large-scale studies have proven beyond a shadow of a doubt that mutual fund investing will almost never beat index funds, and that it is extraordinarily difficult (some say impossible) to pick a mutual fund ahead of time that will beat the market. Another constant of these studies is that fewer and fewer mutual funds are actually beating the market relative to the rates of yesteryear. One common assertion is that the quickly-growing hedge fund industry has poached the few bright stars in the mutual fund world, leaving the scene with a bunch of “closet indexers” as Ed Rempel likes to say. Given what I have learned about the compensation levels in the hedge fund world, and the freedom those investment managers have, I am quite certain this is the case.

Why I’m a Bad Canadian

I grew up in southern Manitoba near the USA border. I loved football as a kid and I still do today. When I was young, I like watching CFL football because it fun, it was what most people around me watched, and I wanted to fit in and cheer for the home team (the beleaguered Winnipeg Blue Bombers). As I got older I started to watch more and more NFL games, and now that is what I watch almost exclusively. It’s not that I’m a turncoat non-patriot, it’s simply that one is a minor league, and the other has some of the best athletes in the world. One league pays pretty well for playing a kids game, the other league makes you rich even at a league minimum contract. It doesn’t take a genius to figure out where the talent will flow to. Don’t get me wrong, there are still some really good athletes in the CFL, and occasionally a real diamond pops up – and they are promptly scooped up by the big boys the next season.

“Show Me The Money!”

Much like the CFL, I’m sure there are few stars that come out of the mutual fund farm team. The question is, why would they stick around when there are bigger pay days and brighter lights in the big leagues? Logic says that if there are thousands of hedge funds that pay top dollar and have immeasurably more maneuverability than mutual funds, this is likely a large part of the reason why the majority of mutual funds underperform their benchmark yearly, and why virtually all of them underperform over the long-term after fees are calculated in.

Even after reading about the extraordinary returns that some hedge fund managers are able to produce, I am not at all confident in my ability to pick those managers out, or in my ability to stomach the risks that many routinely take (even though they were ironically created to hedge against risk). I’ll stick to my passive ETF investing strategy and gladly take the average as the big boys duke it out at the top and suck up billions of dollars of investors’ money in the process.

This post was featured in the Wealth Management Carnival, Investment Edition

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