Home » The Rewards & Hazards of Hedge Fund Investing

The Rewards & Hazards of Hedge Fund Investing

by Louis J. Wasser

“Risk comes from not knowing what you’re doing.” Warren Buffett

Suppose your stockbroker said to you something like this: “I’ve got an investment for you that’s going to go big time. Can you see yourself coming into the market for a quarter of a million?”

You hesitate for a moment. Then you say: “Maybe. What’s your commission on this investment?”

He says: “Two percent… PLUS… I get 20% performance bonus on your returns”

When looked at as a sheer exercise in arithmetic, it’s not all that bad a deal. After all, if the fund yields you a 50% return on your money, you’ll come out 30% to the good, minus a performance bonus, and minus a transaction fee.

(You did realize, of course, you’d also be charged a 2% transaction fee, didn’t you?)

Oh, and by the way, don’t shrug off that transaction fee as being chopped liver. That’s 2% on your total investment. So if you fork over 2% of a quarter million, that’s an easy five grand for the brokerage house.

Still, how can you complain about netting $75,000 on a $250,000 investment? Right?

Welcome to the fast and loose game of hedge fund investing. It’s not for the faint of heart. But you always said you were a player, didn’t you? And just in case you think you can go crying to the SEC if things go south… guess what? Hedge funds are not regulated by the SEC, or by any other institution for that matter. You’re pretty much on your own should you decide to trip the hedge-fund fantastic.

Hedge funds have been around since at least 1949, when sociologist Alfred W. Jones arguably created the first one. A lot of money was moved around in them during the go-go Sixties, but, according to Sebastian Mallaby in his book More Money Than God, the two largest hedge funds lost most of their capital in that era:

“Their claim to be hedged turned out to be a bald-faced lie; they racked up hot performance by borrowing hard and riding the bull market. By January 1970, there were said to be only 150 hedge funds, down from between 200 and 500 one year before; and the crash of 1973-74 wiped out most of the rest of them.”

As Mallaby suggests, there is no hedge in many hedge funds. While many of them consist of pooled equity, with some short positions in other stocks to counter-balance the fund in the event of a declining market, they are not required to maintain such positions. The mix of long and short positions exists solely at the whim of the funds’ managers. Over time, the term “hedge fund” has come to informally — and fashionably — signify any unregulated aggressive pool of equity.

Should you invest in hedge funds? If you do, your funds had best be managed by some pretty smart people. Because guess what? As of the end of 2013, hedge funds trailed the performance of the S&P for the fifth year in a row. And let’s say your particular fund comes out ahead and narrowly beats the S&P — you wind up handing over 20% of your winnings to your fund manager. When you play the ponies, at least you get sunshine.

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