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4 Reasons Why Investors Should Avoid Hedge Funds at All Costs

hedge fund Hedge fund activity currently constitutes approximately 30 percent of all equity trade volume. So if you have any experience with equity trading, or even a slight interest in this type of venture, then you’ve probably been tempted to get involved with one of these notorious private investments funds. And make no mistake, hedge funds and those who run them have made a name for themselves in recent years.

Hedge funds have been all over the mainstream news media of late, whether it’s due to huge successes, shocking defeats, or the way that their managers seem to treat billions of dollars as if it were Monopoly money.

Hedge funds are private by definition and only certain investors qualify to partake in them. If you’ve climbed your way into this category as a result of a strong record in equity or futures trading, you might feel compelled to throw your money in with the über-rich, thinking that it’s a sure way to become one of the elite. But be warned, hedge funds are not all that they are cracked up to be. In fact, for an educated and conscientious investor, hedge funds can be a nightmare.

These four curious characteristics of hedge funds make them different than many standard investments. If you don’t bat an eye at this list, then go for it and you’ll at least enter the fray with your eyes wide open. But if anything in this description of hedge funds surprises you or makes you the least bit uncomfortable, then it might be best to stick with what you know.

1. Lack of oversight:
The SEC does not require a private investment fund to register with them or any other regulatory body if it is comprised of fewer than 100 investors. Combine this with these funds’ tendency to lean heavily on offshore investments and hedge funds are operating in a virtual vacuum. While too much government oversight can hamper the performance of an investment vehicle, too little means that the people handling your money aren’t accountable to anyone, including you.

2. Managers with little to lose:
When investors are invited to contribute to a hedge fund, the manager sets a high-water mark for returns. If your manager meets this goal, he will retain a full 20 percent of your returns, in addition to the couple of points in assets that he is already collecting on an annual basis. And what happens if your fine manager doesn’t meet this lofty goal? With all that he has to gain, failure must destroy him, right? In fact, you and your fellow investors will eat all of the losses and your manager will merely move on and set up shop somewhere else, none the worse for wear.

3. Totalitarian mindset:
When you invest in a hedge fund, you are putting your assets entirely in the hands of one single person, and that is a dicey proposition any time that that person isn’t yourself. The manager of the fund makes all of the investment decisions that determine the success or downfall of the fund, and even a manager with a great track record is fallible. If your manager gets in a fight at home or catches a flu bug, your portfolio could suffer. Worse yet, if your manager steps down and hands the reigns to someone completely new, you and your fellow investors could be in serious trouble

4. Short life spans:
The average life of a hedge fund is only three years, which means that employing this vehicle is unwise if you have a long-term strategy in place. One out of every ten hedge funds collapses each year, making this industry as volatile as almost any other venture out there. An investment with such a short shelf life might not be the way to go if you are a typical investor who has the long haul in mind. Maybe better to keep your money in a high interest savings account instead.

Comments (19)
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  1. Tori said:
    on July 23rd at 03:33 pm

    Excellent information! I will provide a link to this on my site. If you’d like to give me a link in return, that would be great!
    Tori

  2. Chris said:
    on July 24th at 01:51 pm

    Garbage. period. I work in the hedge fund industry, and the main problem is that most investors lack the willingness and knowledge to conduct proper due diligence on hedge funds. Hedge fund of funds are a more diversified way to access alpha generators. In our due diligence includes qualifications that counter every argument the author posits. We look for strong track record, significant personal investment of the managers, full transparency, and risk budgeting. So, before you bash something you don’t understand, do your homework.

  3. Obi-Akpere said:
    on July 25th at 02:34 am

    I like this article, it’s really good stuff.

  4. Bill said:
    on July 25th at 09:36 am

    I agree with this article in that a typical Investors should not invest in single strategy hedge funds. But it is clear that this article is written by someone outside the industry and who has very little knowledge of it outside of what they have seen on CNBC and read in the Wall Street Journal. A diversified exposure to hedge funds makes a great deal of sense on a lot of levels. I run a multi-strategy/Fund of Hedge Funds and while I agree that a typical investor should not invest in a single strategy hedge fund I completely agree with Chris above regarding his comments on a diversified approach to Hedge Funds.

    There has to be something to Hedge Funds if David Swenson manager of Yale’s endowment has been utilizing them in his portfolio since the 80’s.

    I’d suggest if you have the means to, find a good Fund of Hedge Funds and allocate 20-40% of your portfolio there. I’d be willing to bet that you’ll significantly reduce the volatility of your overall portfolio without a significant change in return.

  5. Bill said:
    on July 25th at 09:44 am

    http://seekingalpha.com/article/86721-ignore-the-press-hedge-funds-still-a-viable-investment

  6. Cindy Gonzalez said:
    on July 29th at 11:41 am

    Well said Chris & Bill. Had an experience with an investor so ignorant on what Hedge Funds could do for her real estate portfolio ( Yes – there is risk)…she hired an attorney who had no clue when advising her in regard to Hedge Funds – she lost millions of dollars by taking this attorneys advice on something he had no clue about. Just because he is an attorney doesn’t make him the god of Hedge Funds…HELLO

  7. Dan Tanner said:
    on July 29th at 10:56 pm

    Hedge funds serve a purpose and they are not for everyone. Average people cannot join hedge funds.

    http://indexoptionstrading.alliancemtg.com

  8. Dividends4Life said:
    on July 31st at 07:28 pm

    I see hedge funds as a disaster waiting to happen. Excellent read!

    Best Wishes,
    D4L

  9. Narayana Rao said:
    on August 1st at 02:50 am

    Professional portfolio, investment or trading managers are a reality in investment scene for a long time. As is mentioned in the article itself, hedge funds are for high networth individuals. It is assumed that they know the risks of trading and are handing over a portion their funds to a professional trader who is bound by common contracts and agreement law. If somebody complains to the SEC, SEC can investigate the funds. It does not prescribe on a regular basis, as in case of mutual funds. So a call for not investing in hedge funds is like a call not to do trading in the market. No body is going to listen. Hedge funds have come a long way to become an acceptable investment vehicle for institutional investors. Losses should not scare traders. They have to modify their trading strategies, tighten their money management strategies but should not run away. Well they man run away if they are convinced that trading is not for them anymore. Then they can become long-term investors through mutual funds or on their own.

  10. Bret said:
    on August 2nd at 11:11 am

    Outstanding article.

    You clearly presented the dangers of investing in hedge funds without demonizing them as an investment option.

    I think the substantial risks and fees of hedge fund investing have been swept under the carpet and the sucesses have been highly glorified. Now that there have been a couple of high-profile failures, hopefully the industry will act conservatively to avoid regulation. Right now, hedge funds are still a pretty risky proposition for investors.

    I also find the comments of the hedge fund people to be a little self-serving. It’s hard to conduct due dilligence on investments that aren’t transparent. And, judging performance on an average three year track record isn’t very useful either. If hedge funds were such a great investment, they wouldn’t be consistently going out of business.

    I wonder how much of their own money these commenters have intested in their hedge funds. My opninion is that hedge fund managers are profiting from the risk, instead of sharing it with investors.

  11. Wealth Journey said:
    on August 3rd at 09:44 am

    Well, that is the thing with blogs. If you write well enough, you will be consider an authority. Even when you have no experience in the actual investment itself. Of course, it doesn’t mean that if you have experience, you will be more qualified. But at least, I can say that I have tasted the apple and I know how it taste like. If it’s a bad fruit, I will tell it like it is.

    Though I agree that investing into a single hedge fund is likely a high risk bet. However, if you invest in a fund of hedge funds, you will actually be able to reduce your risk as well as volatility quite a fair bit.

    I’m now currently 5% allocated into 2 fund of hedge funds and I can say that while the rest of my equity portfolio is negative, the fof is actually positive. And the total portfolio is only down around 0.6%.

    I’m sure the merits of a fof is that in a bear or sidewar market, it might outperform your long only strategy. But in a bull market, it might underperform your long only strategy.

  12. Anonymous said:
    on August 29th at 04:02 pm

    Thanks for describing hedge fund investment for what it is, which is basically high stakes gambling. Your critics are either players or the ones rolling the dice, who are fighting against any oversight of their games while wanting to have unregulated access to investor funds(anyone with money or a retirement fund).

  13. Anonymous said:
    on September 10th at 10:10 pm

    This article is somewhat correct but should be titled, “4 Reasons Why an Unsophisticated Investor Should Avoid Hedge Funds”. Unfortunately, of the four reasons provided only the first seems to be accurate. The SEC assumes that if you are wealthy you should be sophisticated enough to perform the proper due diligence to determine whether a hedge fund is a sound investment and therefore do not need to be protected like a layman investor. If you are wealthy but really a layman investor, stick to a fund of funds. Points 2, 3 and 4 are silly. On point 2, if a manager performs poorly, investors pull their assets out of the fund and the manager is left with nothing. And investors in hedge funds are more demanding, as they should be given the fees they pay in expectation of alpha generating talent. On point 3, a large percentage of wealthy investors put their fate in the hands of wealth managers at boutique firms or in private client services groups at large institutions, ultimately relying on one or two individuals. At the end of the day, you should put your wealth in the hands of someone you trust and has the requisite experience. If you aren’t willing to do your homework on who invests your wealth, stick with cheap, diversified beta exposure provided through ETFs and index funds (which on a risk/return basis are far inferior to a hedge fund index or fund of funds). On point 4, registered investment vehicles also have short life spans. This is a better point for how most investors are too short-term focused and instead should be focused on sound, long-term strategies and results. Finally, when a talented manager chooses to manage investor’s assets through a hedge fund structure they are deciding what type of business they would like to run. The lightweight business structure of a hedge fund allows moderately wealthy investors to access manager talent that would otherwise only be available to larger institutions and family offices. Unfortunately, the moderately wealthy have to get in early before the funds grow too large and focus solely on the larger investors. If you take control of your fate and take the time to seek out the good managers though (and have the intellectual capacity to do so), the positives can far outweigh the negatives.

  14. Palin said:
    on May 3rd at 10:42 pm

    I hate when hedge fund managers take unnecessary risk because it is not their money.The 2008-9 financial meltdown has made the public aware of what they do.

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