JULY NEWSLETTER

In the interests of full disclosure let me just state up front that in general I am not a fan of hedge funds, at least not for individual investors. The concept itself, an account managed to produce absolute returns, in good markets and bad, is very appealing. My problem arises with the leverage and risk hedge funds frequently employ, and the fees they charge that reduce returns to a point where you are generally not adequately compensated for the risks they are taking with your money. For very large pension funds or endowments that can negotiate reduced fees and pay no taxes, some of these funds make sense. For the rest of us I believe they make little sense.

The fact of the matter is it is going to be harder and harder for the average hedge fund to post superior returns. About 20 years ago when the hedge fund concept was new and there were relatively few players it was very possible to take advantage of short term anomalies in the markets to make money. Today there are literally thousands of hedge funds with more money, larger staffs, and better computers, all chasing essentially the same anomalies. Market opportunities tend to be smaller and more fleeting forcing the hedge fund managers to increase their leverage (borrow money on margin to increase the size of their bets) and take larger risks for smaller gains. The temptation, and need, to take big risks is increasing as the hedge fund industry grows.

Like any group of investment managers, some hedge fund managers are better (or more lucky) than others. Unlike most traditional money managers, the majority of hedge funds have only been in business for a few years which makes the selection of a good manager a difficult task. Furthermore, given the compensation structure of most hedge funds, the truly successful managers can make tens of millions of dollars a year and quickly loose their motivation to stick with the business as they become fabulously wealthy. Good managers get rich and retire, mediocre managers keep at it as long as they can afford to stay in business. Here again, I would argue the trend is toward mediocre returns

The newest concept for individual investors in hedge funds is a fund-of-funds that does the manager selection for you by distributing your investment over several managers, thereby reducing the risk that you have all your assets with a bad manager who looses a large chunk of your money. While a reasonable concept, fund-of-funds managers need to do a fair amount of due diligence in manager selection and monitoring, services for which they have a right to get paid. Unfortunately, adding their fees on top of the hedge fund managers’ fees creates a tremendous drag on your return. It’s this issue of fees that makes me most reluctant to recommend hedge funds. While one can argue that a substantial fee is justified where you make a high return, the fact remains that unless you are lucky enough to only invest with the top performers, you’re more likely to end up paying a lot in fees for little increase in real after tax return.

Let’s take a closer look at the fee issue. The "standard" hedge fund fee structure is 2% of assets invested as an annual fee and an additional to 20% of the gross gain. If there is a fund-of-fund manager involved you can figure they you will add another 1% annual fee and an additional 10% performance fee to the overall costs. Assume you were lucky enough to get an excellent return from your hedge funds, say 20% (almost twice the long term average return of the S&P 500). If our hedge fund is typical, the managers will take their 2% management fee and then the 20% performance fee, reducing your return to 14.4%. Now further assume you’ve prudently decided to spread your risk through a fund-of-funds manager who takes his 1% and 10% in fees. Your 20% gross return is now reduced to 11.66%.  Unfortunately, we haven’t yet considered taxes.  Hedge funds are seldom very tax friendly because they usually have very high portfolio turnover rates. In other words, they seldom hold their positions long enough to enjoy lower, capital gains tax rates. If you live in a state with relatively high taxes like California or New York, your combined State and Federal tax rate is probably about 40%. When you factor this into the pretax 11.66% return we calculated above, the after tax return drops to 7%. In other words, after fees and taxes our hypothetical hedge fund investment netted the investor only about a third of the initial 20% gross return, the rest was lost to fees and taxes.  If your hedge fund manager was less successful in producing a superior return, your after tax return will be even worse.

By means of comparison, if you bought an S&P 500 index fund and held it a year, virtually all of your return would be taxed at the much lower long term capital gains and dividend rates. Assuming a gross return for the S&P of 10% (half the return of our hypothetical hedge fund investment), a management fee of 0.5% and a combined state and federal capital gains tax rate of 25%, your index fund investment would yield 7.12% after taxes, actually higher than the hedge fund that started out with double the return. If the index investor holds this investment over several years the capital gains taxes are effectively deferred making the benefits to the index fund investment even higher. In addition, unlike most hedge funds, your index investment remains fully liquid and by definition pretty much no more risk that the overall market itself.

As you can see, in spite of what you may hear from your neighbors, coworkers and even some brokers, hedge funds are not necessarily a great investment. While they may make sense for pension funds, in my opinion they make little sense for individual investors with long tern investment horizons.  As always, I welcome your questions and comments.

Randy Gridley

July, 2005