I don’t understand why anyone invests in hedge funds. I assume it’s because they believe these funds can magically deliver outsized returns without additional risk. There is a lot of data to the contrary, but few investors take the time to read it. In one exhaustive study, Burton Malkiel, author of A Random Walk Down Wall Street, and Atanu Saha looked at a database of more than 5,500 hedge funds. Here are some of their conclusions:
- Hedge funds are far riskier and provide much lower returns than is commonly supposed.
- Investors in hedge funds take on a substantial risk of selecting a very poorly performing fund or worse, a failing one.
- Funds of funds, which are hedge funds that invest in other hedge funds run by managers believed to be exceptionally skilled, don’t achieve superior results to the industry as a whole.
- Every major category of hedge fund (eleven categories) on average failed to provide a higher risk-adjusted return than the S&P 500 from 1995 to 2003. Only one category (emerging markets) provided a higher unadjusted return than the S&P 500.
An article by John Cassidy in the New Yorker found that, after fees, the returns in 80 percent of the funds studied fell short of their benchmark index. His findings were consistent with the conclusions of David Swensen, author of Unconventional Success: A Fundamental Approach to Personal Investment. Swensen found that the high fees charged by hedge funds made generating risk-adjusted excess returns “nearly an impossible task.”
Hedge funds implode with alarming regularity, often leaving investors with nothing more than the thrill of chasing big returns. According to a Web site that tracks hedge fund failures, at least 117 funds and 71 major fund families have imploded since 2006.
A minority of these funds were outright scams. Samuel Israel III is now serving a 22-year prison sentence for running funds revealed by the SEC to be a Ponzi scheme. Of course, no one can top Bernie Madoff’s scheme. He claimed he managed $50 billion with annualized returns of 20 percent. Investors are just now beginning to see a trickle of their funds being returned to them through the efforts of the trustee in bankruptcy.
Investors who have been scammed by hedge fund managers are getting more creative in seeking to recover their lost assets. According to an article in the Wall Street Journal, investors in Life's Good Stabl Mortgage Fund (the name alone should have been a red flag) have filed a lawsuit against Morningstar for giving this fund a five-star rating (which was subsequently deleted). The SEC determined the fund was a Ponzi scheme and the fund has now closed. Morningstar correctly notes that it makes it clear that its hedge fund ratings are based only on self-reported data from fund managers.
These hapless investors have stars in their eyes. They are attempting to transfer their own accountability to Morningstar, which makes no claim to being able to detect fraud by hedge fund managers. I don’t like their chances in Court. I sympathize with victims of scams, but investors need to understand there is no free lunch in investing.
Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.