October 31, 2006

22 Reasons Why Hedge Funds Stink For the Average Investor

Making positive or negative headlines, hedge funds are doing it with a splash, creating mighty waves rather than tiny ripples. On one hand you have success stories like George Soros and his macro fund, Soros Fund Management, who earned not only a billion dollars with his shrewd currency speculation, but also the envy of all and sundry in the industry. On the other end of the spectrum are the colossal disasters like Long-Term Capital Management and Amaranth Advisors LLC that were, and still are, the talk of the town for the massive losses they suffered because of poor investment calls.Soros

No matter which way its fortunes swing, the $1.34 trillion industry is continuing to grow and flourish. Investors are being baited with promises of profound profits, even as the funds themselves shroud their activities in a cloak of secrecy. For those who find themselves oscillating between “should I” and “shouldn’t I” on the investment scale, here’s a list of 22 reasons why hedge funds are not the average investor’s cup of tea!

1. Risks – not to life and limb but to cash and currency: Hedge funds are prone to both investment and operational risks. The choice of strategy, the money earmarked for each plan, and the instruments chosen for investment – all contribute to investment risk. Operational risk rests with the fund’s policies, business methods, and accounting and reporting methods.

2. Possible strategic upheaval: Hedge funds use irregular trading strategies like derivatives, options, and short selling in their bid to generate absolute returns (positive returns irrespective of a bull or bear market). As a result, volatility is very high. Returns do not follow the natural normal distribution; they are skewed in what is called a fat-tail distribution, which in plain English means that there are small probabilities of large losses.

3. Promises made but hardly kept: Hedge funds promise spectacular returns on your investment. The catch here is that if something is too good to be true, it generally is. The returns are not as projected most of the time.

4. Long arm of the law not long enough: Hedge funds are not required to be registered with any regulatory body such as the U.S. Securities and Exchange Commission (SEC) unless they have over 99 investors. The absence of regulations and the uncertainty of offshore investments make hedge funds a doubly dangerous investment vehicle.


5. Special keys needed to enter portals: Investors have to be “accredited”, which means that they meet certain minimum requirements – a net worth of $1 million, or an individual annual income of $200,000, or a joint annual income of $300,000 (two years minimum), or being a general partner, executive officer, or director for the issuer of an offered security.

6. No see-through walls here: The lack of transparency is one of the biggest disadvantages of hedge funds. Transactions, strategies, and operational tactics are generally kept under wraps for fear of a competitor gaining a financial edge. This works out adversely for the investor who is unable to see how his/her funds are being used to generate returns.

7. Hedge funds - haven for crooks: Fraud, scandals, allegations of insider trading, meltdowns – these are run-of-the-mill occurrences for hedge funds. The lack of sufficient regulations facilitates moral and financial wrongdoings, which, at the end of the day, are not advertisements for the industry.

8. You’re putting all your eggs in one basket: The success or downfall of a hedge fund is largely dependent on the manager’s financial acumen and savvy in picking the right investments. Most investors pick hedge funds based on the manager’s reputation in the financial markets. If he/she retires, steps down, dies, or is otherwise indisposed to carry out his/her duties, investors may find themselves in a quandary. Managers who stick to a single strategy even when it is not right for present market conditions also pose risks for investors.

9. Managers skimming the cream: Managers of hedge funds have their cake and eat it too. Besides taking 1 to 2 percent of assets annually, they retain 20 percent of returns, both realized and unrealized. This proves to be very costly for investors. The 20 percent is usually allowed only if returns exceed a certain amount called the high-water mark. Failure to meet this minimum requirement may see managers closing up shop, only to open it elsewhere with a new base high-water mark. Investors end up holding the losses incurred.

10. Liquidity and its lack thereof: If you are looking to redeem your investment midway, bear in mind that hedge funds manage assets that are largely illiquid. The problem of liquidity is seen both on the assets – the quick liquidation of assets translates into huge transaction costs – and on the liabilities side – possible investor redemptions and high leverage - of the balance sheet.

11. There’s no passing the buck: Unlike mutual funds and stocks, there are no secondary markets for hedge funds. You cannot transfer or sell your interests in a fund.

12. Taxing troubles: Hedge fund transactions are often complicated and give rise to tricky income and capital gains tax issues. The choice of certain strategies may result in tax information being sent out late to investors, thus causing them tax problems.

13. Can’t get out while the going is good: Ok, your fund is doing spectacularly well, and you wish to gather up your windfall and leave. More often than not, this is not a possible option because of what’s call the lock-up period, where investors are not allowed redemption options for a minimum period. A typical lock-up period is between one and three years. Closure or failure of the fund brings more woes – you may get only a part of your investment back.

Firefly 14. Hedge funds - the fireflies of the financial family: Long term investments are not feasible when the average life of a hedge fund is only three years. In spite of all the new funds mushrooming over the world, an estimated 10 percent of funds wind up operations every year.

15. Manager’s pet, it better be you: Some investors find favor over others through the use of side letters. They are offered more transparency of the fund’s actions, lower fees, and shorter lock-up periods. This could end up affecting the positions of other investors.

16. Too crowded for comfort: With the implosive growth of the industry, there are more managers trying to jump on the strategy bandwagon that is currently in vogue. This could lead to returns diminishing over a period of time.

17. Hypothetical (hyped up?) performance: Hedge funds generally tend to state pro forma performance, as a result of which reported performance is considerably different from actual trading results. At times, excellent performance is based on one good trade, which may be the result of a stroke of luck rather than judicious decision-making.

18. To each his own does not work here: A conflict of interest between investors and the manager can cause strategies being changed mid-stream, especially if the investor has sufficient clout and knows the right strings to pull. Strategies that have a high probability of success in the long run may be abandoned because of investors railroading managers when there is a performance reversal.

19. History may not repeat itself: Past performance cannot be used as an indicator of a hedge fund’s current or future performance. Stellar returns are not a guarantee just because a fund has done well so far.

20. Molehills may be called mountains: Hedge funds tend to overstate their net assets under management to hype up performance details. Transaction values on trades conducted during the course of a month may be used instead of end-of-the-month numbers.

21. Reading between investment lines is an art: Accredited investors who earn pots of money are not necessarily shrewd and canny when it comes to assessing the right investment portfolios. Which means that being “accredited” is not protection enough to invest in hedge funds.

22. Fractional gains, whole losses: Managers and general partners share in the profits when a hedge fund generates large returns. But when the tide turns and the losses start pouring in, the fund is taken out of circulation, and a new one germinates, most often in an overseas location. The ultimate losers are the hapless investors.

The reasons provided above are just a nutshell view and do not detail all that’s wrong with the hedge fund industry, but they should suffice to deter those who are averse to high risk and volatility from putting their trust and money into such investment vehicles. For those who decide to go ahead in spite of all the pitfalls, they would be wise to follow experienced counsel and get satisfactory answers to certain questions before getting their toes wet.

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Superbly written, simple and to the point. A must read for the average investor wanting to get rich through hedge funds.

Posted by: Varasidhi.J | Nov 1, 2006 10:05:04 PM

Truly incisive analysis. Provided all relevant details in a concise and reader friendly manner. Thanks.

Posted by: Anita | Nov 5, 2006 11:45:49 AM

A good job of describing the hedge fund space - but one correction -there are secondary markets for hedge funds, they are just on foreign exchanges - see my blog


for details.

Posted by: world alpha | Nov 6, 2006 10:45:42 AM

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