Forget about Hedge Funds

Hedge funds are shutting at a rate not seen since the financial crisis. In fact, a recent article in Bloomberg News reports that hedge funds, on average, have returned just 2 percent in 2014, their worst performance since 2011. Further, in the first half of the year, 461 funds closed. If that pace continues, it will be the worst year for hedge fund closures since 2009, when there were 1,023 liquidations. The latest fund to close was the $37 billion Brevan Howard Asset Management LLP. And there’s no sign that redemptions will close anytime soon.

The article further notes that many of the closures have been among macro funds, which have, on average, returned less than 1 percent this year. Macro managers have complained that “low interest rates and muted swings in prices” have made it difficult to make money.

Laurence Fletcher’s article in the Wall Street Journal relates the story of Gregory King’s $600 million Heather Capital, illustrating another reason why hedge funds are very risky investments. King pulled in money from major investors in the run-up to the financial crisis, but now the money is gone. Fletcher reports that investors in the fund included a who’s who of the Swiss private-banking world, the $141 billion Ontario Teachers’ Pension Plan and a fund run by Nicola Horlick, a London asset manager once known as the city’s “superwoman.” One investor is quoted in the article as saying that Mr. King made investing in the fund sound “bulletproof,” adding “He knew how to say the right thing and he made it sound like he had this little niche.”

Trouble is the niche he marketed was a sham. Heather Capital’s business model was to step into the void created as major banks tightened their lending and lend money directly to companies. However, many of the loans to property developers were “a fabrication and a sham.”

Heather said it couldn’t reveal who it lent money to because of debtor privacy laws. That lack of transparency is a major risk of investing in hedge funds. Managers often operate via a “black box” strategy that affords them unprecedented latitude to invest as they wish. Accordingly, you don’t know what you own, or what you might own in the future. That makes it impossible to integrate a hedge fund into the rest of your portfolio. Other negatives include poor liquidity and exorbitant fees. Charges of 2% of assets, plus 20% of profits above the high water mark are not uncommon. Further, “funds of funds,” single vehicles that hold interests in several other hedge funds, add another layer of fees.

As hedge funds that were once available only to the ultra-wealthy have become mainstream, more investors who simply cannot afford the risks associated with these vehicles have been snared by hedge fund’s alluring promise of higher-than-market returns with lower volatility. It’s this simple – There’s no such thing as a free lunch. In fact, to stretch that metaphor further, why order blindly from a menu and vastly overpay for an unhealthy meal based only on the chef’s word that the meal will be exceptional?

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