For a long time now I have been skeptical of hedge funds.
When the research clearly shows active managers fail to out perform broad-based index funds like VTSAX over time, how could hedge funds? Especially considering active stock funds charge expense ratios (ERs) ranging from ~.5 to 2% while hedge funds take 2%, plus 20% of any gains. 2&20 as it is known in the biz. Yikes.
Who in their right minds would pay such fees, unless these things truly had the “secret sauce,” for which you know, if you’ve read much of my work, there is no evidence.
Turns out I was right. There is no hedge fund secret sauce. Not only do they underperform index funds like VTSAX, the gap is huge. As you’ll see in the guest post below.
Of course, the managers of these funds would point out outperformance isn’t the goal. Hedging against the downside is.
But from my perspective, the cost for that hedging is too huge and not just in fees.
Back in 2008, Warren Buffett bet a million dollars of his own money that, over the course of the next ten years, a simple S&P 500 index fund would best a selection of top hedge funds.
Bad timing on Warren’s part.
This bet was placed just before the infamous stock market crash of 2008-9, the worst crash since the great depression. And crashes are when hedge funds should shine.
Indeed they did, coming out of the gate with a huge lead.
But crashes are rare and, as Jack Bogle once observed, expenses are forever. By the end of the ten year bet, Buffett’s index fund not only won, it trounced the hedge funds. Not even close.
Buffett is a multi-billionaire due to his decades of investment acumen. But so are the hedge fund managers. So, the question is, if their investment performance is so poor how do they do it?
The answer:
That extraordinary 2&20 fee structure.
The skill here isn’t investment acumen, it is convincing large institutions and very wealthy people to put their money in your funds. Do that, pull those 2&20 fees, and the next thing you know old Jed’s a billionaire. (bonus points if you get that old reference)
So how do they do it? How do you convince presumably smart, sophisticated investors to pay 2&20 for poor performance?
I’ve been thinking about this for some time now with an eye towards writing a post about it, and I have my own ideas. But a few months ago I came across the work of Ben Carlson.
Ben writes A Wealth of Common Sense and he’s one of the most astute observers of investing I have ever read.
He’s been managing institutional portfolios his entire career. He’s developed portfolio strategies and created investment plans for foundations, endowments, pensions, hospitals, insurance companies and high net worth individuals. Oh, and he’s written four books on saving, investing and money.
In short, he is intimately familiar with the world of institutional investing where the hedge funds play. And he knows how they play.
After reading his eye-opening post below, you will too.
10 Reasons People Invest in Hedge Funds
by Ben Carlson
Ben
From 2008–2022 the S&P 500 was up 8.7% per year.
That return number does not include things like taxes and investment fees but the good news for investors these days is you don’t have to pay much at all in terms of fees. The Vanguard S&P 500 ETF (VOO) charges just 0.03% in annual expenses.
But what if you were forced to pay the typical hedge fee schedule of 2% per year in management fees along with 20% of profits (2&20)?
The returns would drop to just 4.8% per year. So the 2&20 model would have eaten up more than half of the stock market’s return.
Institutions such as pensions, endowments, foundations and family offices gladly pay for this fee structure, so surely the returns more than compensate for the egregious fees, right?
I’m sure there are a handful of funds that knocked it out of the park but hedge funds as a group certainly failed to keep up with either the U.S. stock market or a simple 60/40 portfolio of stocks and bonds:
This period started with a bear market in 2008 and ended with a bear market in 2022, yet hedge funds as a group failed to come close to keeping up.
To be fair, there are all kinds of different hedge funds out there. These funds aren’t meant to beat the stock market. Instead, they promise to offer drawdown protection and lower volatility.
Fair enough, but the returns are still rather atrocious considering how much money investors pay for these funds.
So why do wealthy individuals and large institutional investors continue allocating to hedge funds if the fees are so high and the returns so poor?
Here are 10 reasons:
1. Most hedge fund managers are brilliant.
These people don’t raise millions or even billions of dollars without having a high level of intelligence. When you meet face-to-face with the best hedge fund managers it’s almost impossible to walk away unimpressed. Most of the best funds have made it so you almost feel entitled and lucky to be handing over your money to them. That’s how good some of these managers are at persuading people of their brilliance. Some people will never be able to resist a combination of charm and a compelling story.
2. Hedge funds are more exciting than other forms of investing.
It’s much easier to blame others or come up with excuses when implementing a complex approach to portfolio management. Keep things too simple and you’re the only one to blame when things go wrong. I’m always amazed at how much people underestimate the role of career risk in the investment industry. It could be one of the biggest behavioral sources of market inefficiency when you consider how much money professional investors collectively manage.
Non-correlated returns, stock-like returns with bond-like volatility, upside participation with limited downside risk and alpha generation all sound very impressive when you have to answer to a board that oversees your institutional fund. If nothing else, hedge funds are interesting. The message is very appealing to certain groups of investors.
3. They have some of the best sales and marketing teams in the fund industry.
With high fees come plenty of resources to hire the best and brightest to build your support staff. Not only are the portfolio managers interesting to talk to, but the people who manage the relationships for these funds are the best in the business. They have the sales process perfected.
4. There’s always a good time to invest in a hedge fund…just ask them.
This is true with any money manager, but hedge funds have truly turned this into an art form. In the aftermath of the 2008 financial crisis, investors were told they had to invest in hedge funds because, “Look what just happened,” playing up to people’s recency bias. And following the bull market investors were told they had to invest in hedge funds because, “Another crash is on the way…” Hedge fund managers are the most paranoid, anti-Fed, anti-establishment investors out there. They’re very good at playing on investor fears to raise capital, and fear sells.
5. Hedge Funds are a status symbol.
I was sitting in on a panel a few years ago with a handful of mid-sized endowments and foundations. These funds had a few hundred million dollars compared to the billions managed by everyone else in the room. One CIO told the crowd that his fund “only” had 20% of their fund allocated to alternatives like hedge funds. But he was quick to point out that the allocation would certainly grow in the coming years. It was like he was ashamed that his organization’s portfolio didn’t have 50-70% in alts like everyone else (pretty standard these days for larger funds). Peer pressure and the status symbol of creating a “sophisticated” portfolio is a real issue for many of these organizations, whether they’re willing to admit it or not.
6. There’s an assumption that you get what you pay for.
Higher fees lead to better performance, right?
7. And that a complex approach must be better.
The more clever the pitch the better the performance, right?
8. Peer pressure.
Consultants, advisors, family offices and institutional investors are constantly looking at best practices to keep up with the rest of the industry. On the institutional side of the business there is plenty of peer-to-peer sharing of manager recommendations and due diligence that goes on because no one wants to be surprised by a lack of information. Everyone likes to think they’re a contrarian in this business, but it always feels much safer to go with the herd and do what everyone else is doing. Hedge funds are a perfect example of this as the large allocators of capital typically all invest in the same funds.
9. There are funds out there with amazing track records.
It’s not like it’s all smoke and mirrors. Some people out there seem to assume that rich people and institutional investors really just like shoveling money into the furnace by paying 2&20 to underperforming hedge funds. As I said in my last hedge fund piece, there are great funds out there. But the chances that you are going to have access to them is slim to none. Yet hope springs eternal.
10. Ego.
Most big investors are unwilling to admit that they’ll never be able to invest in this small group of outperforming funds or pick the best emerging managers, but that doesn’t stop them from trying.
A number of years ago, Ray Dalio of Bridgewater Associates was asked how many hedge funds are worth investing in. This was his response: “There are about 8,000 planes in the air and 100 really good pilots.”
And Dalio should know. One of the all-time great hedge funds, Bridgewater manages around $150 billion for many of the largest institutional investors in the world.
It’s amazing how many people assume they only invest in the top echelon of funds. It makes you wonder who all these people are investing in the rest of funds out there. It has to be someone. The fact remains that the majority of investors in hedge funds are ill-equipped to invest in this space. Most people have been or will be disappointed by their hedge fund investments.
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JL here again…
Ben’s post is pretty much what I expected. I’ve been looking at and thinking about how these hedge fund guys pull this 2&20 deal off for a while now. I’d pretty much figured it was as Ben lays it out.
And yet…
It is just incredible to me still that institutions pour money into these things. The allure of being part of the club, and being wined and dined at that level, must be breathtakingly intoxicating.
Still, double the return with indexing and virtually none of the cost should count for something.
As I write this, the MegaMillions lottery prize is up to 1.25 billion dollars.
Now to be clear, media hype notwithstanding, if you happen to win you are not going to be a billionaire.
You are either going to take your winnings in much smaller installments over 29 years, or you’ll take the lump sum of $625.3 million.
But don’t forget your Uncle Sam will want his 37% cut, leaving you with ~$394 million. Plus, unless you live in one of the few states without an income tax or that doesn’t tax lottery winnings, another 5-10% or so will evaporate.
So, sorry, not a billionaire. More like a 1/3 of a billionaire.
Even so, it is enough to cash the check.
Now your question becomes,
“Do I follow The Simple Path to Wealth or seek out a hedge fund to manage my money?”
Well, to be clear, if you decide by looking at who is richer, your decision is easy.
If the typical hedge fund billionaire was walking down the street, saw my entire net worth lying on the sidewalk and bent down to pick it up, he could be justly criticized for his poor time management.
Based on that metric your course is clear.
But now you have another.
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The FIT Position
For decades I’ve noticed teachers being told, and telling themselves, that financial independence (FI) is not for them.
Then I met Brandon Spice and Dave Fleischer, two educators who are showing other educators not only how they CAN achieve FI, but why they are ideally positioned to do so.
They’ve had me on their podcast:
https://www.buzzsprout.com/1674073/10662549
Now their new book has just been released.
Oh, and I wrote the foreword. 😉
