Money
You’ve got to play it smart
I’m sure you’ve heard of a hedge fund or maybe not. This is the official definition of it:
A hedge fund is an actively managed investment pool whose managers may use risky or esoteric investment choices in search of outsized returns.
In other words, rich people give their money to an investment fund that invests their money in different assets.
They often pay enormous fees to these hedge funds. Most hedge funds have a fee structure of 2/20. This means that they charge an annual fee of 2% and take a cut of 20% on the profit that the investor makes. Pretty enormous.
To put this in perspective, let’s say you invested $1 million and got a return of 10% on your money. Expect to pay an annual fee of $20K and another $20K cut on your profit.
Some hedge funds charge a higher fee. Let’s take the example of the Medaillon Fund, the best performing hedge fund ever. This fund managed to get an average annual return of 71% per year before fees.
The return is pretty gigantic and so are its fees. They have a 5/44 fee structure. They take an annual fee of 5% and a 44% cut on profits.
In 2021, the hedge fund manager and founder, Jim Simons had a salary of $3,4 billion. His net worth is estimated to be $28 billion.
Btw, if you want to invest in this fund, only employees and former employees can invest in it. Too bad.
Let’s start with the first why. Why are hedge funds a terrible investment? Well, it’s because they have too much diversification. See, a hedge fund can invest in all sorts of assets like real estate, stocks, bonds, derivatives, and commodities.
All of these investments generally have a lower return than the stock market. That’s also why Warren Buffett is such a big fan of the S&P 500. They invest everything into stocks.
In 2008, he bet $1 million that the S&P 500 would have a greater return than hedge funds. Obviously, he won the bet. Warren Buffett is such a big fan that he wants 90% of his wealth to be invested in this index after he dies.
Another reason why hedge funds perform so poorly is that they hedge. It’s literally in their name.
This is what Investopedia has to say about hedging:
A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite position in a related security.
Because these hedge funds always need to hedge, they can’t take big risks which could offer big rewards.
TL;DR
- Too much diversification
- Too much hedging
Hedge funds aren’t necessarily a bad investment. Sure, the average hedge fund return was horrible, absolutely horrible over the last 10 years. It’s because it’s the average return, not the median.
See, with the average return, the returns from the biggest hedge funds sway the average. That is why we should use the median return which we don’t have access to, 😞.
There are a couple of hedge funds that have really good returns, better than the S&P 500. But there are some hedge funds that have an unacceptable return.
Where I live, In Belgium, Europe, I looked up a couple of hedge funds. The first one I found was Delen Private Bank. They charge a fee of 1,5% per year.
Their average return is: 7% per year
This is actually not that bad, but still, you pay them so much in fees, just to get a return that is inferior to the 10% annual return the S&P 500 had.
The worst thing is that this is their most aggressive fund. Their most conservative fund had an average annual return of 1,5%. That’s just a disgrace.
I found another hedge fund whose most aggressive fund had an average annual return of 5%. That’s again, a disgrace.
TL;DR
- The average return is not accurate
- Some hedge funds perform well while others perform horrible
Ok, we get it, hedge funds are a terrible investment. Why do the rich invest in them?
When I simply googled this, this is what they said:
Hedge fund investors are looking for an investment that is uncorrelated with the rest of their investments. If the stock market loses value, the hedge fund investment might rise. In other words, investors use hedge funds to increase their diversification.
But when I looked at Delen Private Bank’s returns, I found out that their most aggressive fund lost 47% in 2008 while the S&P 500 only lost 37%.
So the S&P 500 has fewer fees, less volatility, and a greater return.
Some hedge funds perform quite well like Ray Dalio’s bridge water fund but you need to invest at least $7,5 million in their fund and pay a minimum fee of $500.000.
My thesis
My thesis is pretty simple, the people who invest in hedge funds either don’t know that the S&P 500 exists or simply don’t trust themselves to invest their money because they fear that they will lose everything.
I’m sorry, my thoughts were all over the place in this article. This article was quite difficult to make because there is no right answer. Are hedge funds a bad investment? Kinda, but they have less risk.
Why do the rich invest in them? Because they want something uncorrelated with the overall market but I then found out that some of them didn’t hedge at all.
I would love to hear your thoughts, Trevor Stark about all of this.
Anyways…
What are you doing? Go read some of my other articles, at least if they interest you:
