A Mystery in Hedge Fund Investing

When I look at hedge funds, there are three data points that keep bothering me. They create a pattern that doesn’t make a lot of sense. I hope you can help me understand what I’m missing.

1. Hedge fund performance has been terrible.

In 2014, the Barclay Hedge Fund Index returned 2.88 percent. In that same period, the boring Standard & Poor’s 500-stock index of larger American stocks gained more than 13 percent and the Barclay United States Aggregate Bond Index rose more than 5 percent.

I know, I know, that’s only one year. And one year doesn’t equal a track record. But how about a decade?

For the 10 years ending in January 2015, Vanguard data shows that a basic portfolio of index funds that own every security in a market segment (60 percent stocks, 40 percent bonds) would have returned 6.6 percent a year. The average hedge fund only managed an average return of 5.6 percent a year. In case you’re wondering, the same 60/40 portfolio beat the average hedge fund for three- and five-year periods, too.

We’ve all heard the stories about hedge fund managers who won big and walked away with billions. Although it’s not impossible to identify these fund managers before their big wins, it’s highly improbable. Most of the rest of the people who made a lot of money with them were probably just lucky.

2. Hedge fund expenses are insane.

The amount you pay for an investment has a direct, mathematical correlation to how much money you’ll end up with. John C. Bogle, the Vanguard founder, refers to it as “the relentless rules of humble arithmetic.” The more you pay, the less you keep.

With those “relentless rules” in mind, the typical hedge fund charges 2 percent of assets under management and 20 percent of any gains, though some may charge more or less. Using humble arithmetic, compare those numbers to low-cost, diversified index funds that charge people 0.25 percent (or less, as many do). Now, we’ve reached the point where the data gets really confusing to me. People pay much more and have gotten much less of late when they invest in hedge funds.

3. People continue to invest in hedge funds anyway.

Investors sank more than $88 billion into hedge funds in 2014. Why do people keep doing this?

One assumption might be that they don’t know that hedge funds are just really expensive, underperforming mutual funds for rich people. But given how much people have written on the subject, it’s probably something else.

Maybe hedge funds give people something to talk about at parties. Based on what I hear at different events, some people love sharing the news that they own XYZ hedge fund. It sounds cool, right? Not everyone can invest because of various rules and screenings, so it does convey some sort of social standing, I suppose.

The attraction could also be in the pure entertainment value. Some people enjoy watching ESPN, reading a book or heading outdoors. The really wild people enjoy taking a walk with their spouse or spending time with their children. Perhaps hedge fund investors want the entertainment of buying really expensive things that probably won’t work, on the off chance that they will once in a while.

Or the reason could be more subtle. Americans have a hard time admitting they’re average. Hedge funds have gone out of their way to push the idea that they are better than average. For wealthier people, the desire to claim that golden ticket, to be better than average, may be worth every penny of the insane fees they pay.

Perhaps, however, I’m not giving people who are buying hedge funds enough credit. Maybe they are actually looking for a hedge … fund. You know, something that really and truly hedges against market downturns by betting that certain stocks or market segments will fall. In that case, I can understand the confusion. Given the tear the market has been on, it might make sense to be looking for ways to protect yourself in case of a steep correction.

In fact, that’s what hedge funds were supposed to do in the first place, and there are still funds that do it. You may have to look hard to find them though, because many of today’s so-called hedge funds aren’t really hedges against a sharp drop in the market. They’re audacious, all-in bets on a variety of big market moves or the funds’ fancy computers and software that quickly scrape pennies off transactions valued in the millions. People seeking a true hedge fund need to proceed with caution and make sure a hedge fund isn’t really something else in disguise.

Obviously, I could be totally wrong here. I’m just a guy from the hills in Utah, and this pattern of decision-making could make perfect sense. You may be completely happy with your really expensive, underperforming mutual fund. If so, who am I to burst your bubble?

This commentary originally appeared March 9 on NYTimes.com

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© 2014, The BAM ALLIANCE

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Carl Richards, CFP®

Carl Richards is the creator of the weekly Sketch Guy column in The New York Times and is a columnist for Morningstar Advisor. Carl has also been featured in The Wall Street Journal, Financial Planning, Marketplace Money, The Leonard Lopate Show, Oprah.com and Forbes.com. His simple but meaningful sketches served as the foundation for his first book, "The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money."

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