The Illusionary Allure of Hedge Funds

TL;DR

Hedge funds have high fees, low returns, and additional risks, making them a poor choice for most investors.

Transcript

I’ve talked before about the tendency of investors  to feel like they deserve more than the plain old   market return. This seems to be especially true  as people build more wealth. Anybody can buy   index funds. More sophisticated investments  have high minimums, or require you to be an   accredited investor. The pinnacle of what I  am describing ... Read More

Key Insights

• 🙂 Hedge funds are exclusive, elite, expensive, and lightly regulated financial products.
• 🤱 Hedge funds have high fees, but research suggests that manager skill does not justify these fees.
• 😘 Hedge funds do not offer high returns compared to low-cost index funds and globally diversified portfolios.
• 🖤 Hedge funds lack liquidity and can suspend investors' ability to withdraw funds at their discretion.
• ✋ Hedge funds exhibit negative skewness and high kurtosis in returns, indicating a few winners and many losers.
• ✋ Hedge funds can invest in illiquid assets, exposing investors to higher levels of risk than expected.
• 🥺 The combination of illiquid assets and leverage can lead to significant losses for hedge funds during market downturns.
• 😘 Hedge funds can have a high correlation with the stock market during financial crises, despite claims of low correlation.

Questions & Answers

Q: Why do hedge funds command high fees?

Hedge funds charge high fees due to the supposed skill of their managers, typically 1-2% of assets under management, plus 20% of any excess performance. However, research suggests that manager skill is not the primary driver of returns.

Q: Do hedge funds offer high returns?

Hedge funds, despite their exclusivity, do not offer high returns. Over the period from January 1994 to November 2017, the Credit Suisse Hedge Fund Index returned 7.71%, while a globally diversified equity index fund portfolio returned 9.19% during the same period.

Q: Are hedge funds less risky than stocks?

Hedge funds may seem less risky based on their relatively low standard deviation of returns. However, they exhibit negative skewness and high kurtosis, meaning most investors lose while a few winners win big. The combination of illiquid assets and leverage can also be disastrous for hedge funds during market downturns.

Q: What is the correlation between hedge funds and the stock market?

While hedge funds have a somewhat low correlation with the stock market, this correlation can become high at the worst possible times, as seen in the 1998 and 2007 financial crises. Therefore, relying on correlation data may not be useful in practice.

Summary & Key Takeaways

• Hedge funds are exclusive, expensive, and lightly regulated financial products, with about 3.3 trillion dollars invested in them globally.

• While hedge funds aim to have uncorrelated performance with the market, their high costs, low returns, and additional risks make them a questionable investment.

• Hedge funds lack liquidity, exhibit negative skewness and high kurtosis in returns, and invest in illiquid assets, which can lead to significant losses during market downturns.