Should I buy a hedge fund?
“According to The New York Times, investors are flocking to funds that mimic hedge fund strategies — like long/short and global macro — hoping the extra diversification will help them avoid getting wiped out again. (Alternative bond funds are especially popular this year, as rising interest rates loom as the next mega-risk; long/short funds are the second most popular.) Assets in alt funds have soared past $234 billion this year, from less than $42 billion in 2007, says Morningstar. Alternative bond funds alone have attracted $44 billion year to date.”
At Mills Wealth, our experience has been that high costs usually hurt investors. Many investors fear the pain of short term declines, when often the best protection from declines is prudent diversification, a long term buy and hold approach, and matching your portfolio to your tolerance for risk and needed return.
Hedge funds are very expensive and highly complex vehicles that are usually not ideal for most investors (no matter how sexy they may look or how rich the manager is). It is rare that investors that pay a manager a 2% management fee and 20% of the profits will end up better off than a low cost index fund that buys a broadly diversified basket and similar securities. Low cost market replication funds may not be as exciting as hedge funds but over a couple of decades the low cost strategy has a much higher chance of long term success. That’s one reason why legendary investor Warren Buffet made a high profile 1 million dollar bet that the S&P500 index fund would beat a collection of high cost, high profile hedge funds selected by a successful hedge fund manager. With only a couple of years left, Buffet is way ahead making the point that cost matters a great deal.
I want to remind investors that the best form of protection is diversification, and that the cheapest form of portfolio protection is not high cost hedges it is owning high quality fixed income.
Noble winning Professor Eugene Fama and his research partner Professor Kenneth French have shown in their Term and Credit research (2 of the 5 Factors of higher expected returns) that adding high quality intermediate term government bonds offers investors one of the cheapest forms of portfolio defense.
Investors should be careful when investing in hedge funds. Most research regarding active management like hedge funds shows that less than 3% of managers can outperform their cost and fees. Over time much of investor return is transferred to the managers. Buyer beware – high cost can be dangerous to your wealth.
–Mike Mills, CFP, CLU, CFS
Source on cost to reference:
“It should be noted that although cost is an important determinant of future performance, it is certainly not a perfect predictor. On average, lower-cost funds tend to produce better future results than higher-cost funds (Wallick, Wimmer, and Martielli, 2013; Philips et al., 2014), but there can be exceptions.” https://advisors.vanguard.com/iwe/pdf/ISGSFA.pdf