The mystique of hedge funds is formidable. You have to give them your money and ask no questions. Fees are steep.
Truth be told, however, the actual investments of many hedge funds are quite boring. Like mutual funds before them, hedge fund managers are now caught up in a really tough, competitive game. They have to perform or the redemptions come fast and furious.
See, hedge managers know that the bulk of their gains are going to come from just keeping up with indexes and then, they hope, adding a bit of “alpha” by taking on a leveraged bet on the side.
They’re up against a serious challenge. Their fees — normally 2% of investor assets and 20% of profits, if any — essentially guarantee a subpar performance over time. The two reasons a hedge fund becomes an “ex” hedge fund is repeated losing years or, in many cases, one real whopper of a loss in a single quarter.
Because they start from behind, hedge funds are forced to roll the dice to make up the difference and prove their worth. Their managers don’t have any real problem with taking the risk. It’s not their money, after all.
And if you buy into one, you are by definition accepting that the risk is higher. It’s why hedge fund investors are “accredited,” that is, they attest to their personal wealth and willingness to lose money in the markets. Accredited is a fancy way of saying you can afford to take a hit.
Retirement investors can’t. No retirement investor should be rolling the dice with the gunslinger managers of Wall Street. The problem with gunslingers is that, eventually, they come face-to-face with a faster gun. Somebody ends up face down in the dust.
The far better approach is to accept what hedge fund managers already know: Indexing is a safe, if boring, way to ensure success over the long run.
Indexing with a mix of asset classes, combined with rebalancing, is even better. That way, you get exposure to the more exotic investments in the world without necessarily assuming all of the volatility they bring.
Taking gains where they occur and keeping costs low is truly powerful investing without the high-risk approach inherent in hedge fund thinking. It’s not just common sense, it’s better investing.