We show you why investing in hedge funds is a bad idea -- even if you earn a steady 12% a year for life!
According to a report in the Financial Times, May was the best month for hedge funds in more than nine years. For the record, the Eurekahedge Hedge Fund Index, which tracks more than two thousand hedge funds, was up by 5.2% in May alone.
Of course, given the dramatic recovery in share prices since their March lows, the recent bumper performances by hedge funds come as no surprise. However, the hedge-fund industry took a pasting in 2007 and 2008, when investors discovered that these 'absolute return' funds can produce hefty losses in bear markets, in line with conventional long-only funds.
Why it pays to avoid hedge funds
Personally, I've never invested in a hedge fund, even though many generated mouth-watering returns as asset prices soared during the recent boom years. The main reason for my aversion to hedge funds is simple: their charges are far too high. Indeed, the monstrous mathematics of hedge funds suggest that they amount to an incredible 'heads I win, tails you lose' bet for hedge-fund managers.
Invest in the "D'Arcy Dynamic Returns Fund"!
Let me explain the thinking behind my argument with a simplified example. Let's say that I start my own hedge fund, The D'Arcy Dynamic Returns Fund, or DDRF. (As you'll come to see, the returns are dynamic solely for me and not my investors!)
I start the D'Arcy Dynamic Returns Fund by putting £1 million of my own money into it and amassing another £9 million from investors, for a total of £10 million. As with other hedge-fund managers, I charge my investors hefty fees, as follows:
• an annual management fee of 2% (which I receive no matter how poor my performance); and
• a performance-related fee of 20% of the annual returns generated by my fund.
In hedge-fund jargon, this is known as a standard '2+20' fee structure.
To make my calculations simple, let's assume that I am a master investor -- up there with Warren Buffett, Peter Lynch and others. Indeed, so good am I that I earn my investors a rock-steady annual return of 12%, year after year after year.
(To my knowledge, the only hedge-fund manager who has produced such consistently steady and superior returns was Bernard Madoff. Of course, it turns out that 'Mr Made-off' was running a $65 billion Ponzi scheme!)
So, each year, I take 2% + 20% x 12% = 4.4% of the fund's value in management fees. This has the effect of reducing my investors' return from the headline 12% a year down to a much less attractive 7.1% a year.
What's even worse is that, over time, I will come to own the vast majority of the D'Arcy Dynamic Returns Fund, as the following table proves:
| Year end | Fund value (£) | Total fees (£) | My stake (£) | Investors' stake (£) | My share (%) | Investors' share (%) |
|---|
| 1 | 11,200,000 | 443,520 | 1,563,520 | 9,636,480 | 14.0 | 86.0 |
| 2 | 12,544,000 | 474,886 | 2,226,028 | 10,317,972 | 17.7 | 82.3 |
| 3 | 14,049,280 | 508,470 | 3,001,621 | 11,047,659 | 21.4 | 78.6 |
| 4 | 15,735,194 | 544,429 | 3,906,244 | 11,828,949 | 24.8 | 75.2 |
| 5 | 17,623,417 | 582,931 | 4,957,924 | 12,665,493 | 28.1 | 71.9 |
| 10 | 31,058,482 | 820,345 | 13,234,626 | 17,823,856 | 42.6 | 57.4 |
| 15 | 54,735,658 | 1,154,452 | 29,652,556 | 25,083,101 | 54.2 | 45.8 |
| 20 | 96,462,931 | 1,624,634 | 61,164,060 | 35,298,870 | 63.4 | 36.6 |
| 25 | 170,000,644 | 2,286,310 | 120,325,357 | 49,675,287 | 70.8 | 29.2 |
| 30 | 299,599,221 | 3,217,472 | 229,692,335 | 69,906,886 | 76.7 | 23.3 |
I'm assuming here that no money is taken out of the fund and the fees I charge are re-invested as part of my share of the fund.
As you can see, taking 4.4% of my investors' money each year has a massive impact on their ownership of the D'Arcy Dynamic Returns Fund. At inception, my investors owned nine-tenths (90%) of the DDRF. However, after five years, I own over 28% of the fund, versus 72% for investors. As this game unfolds, I own a larger and larger proportion of the overall fund, reaching 77% after thirty years.
Thus, in the main, you could argue that hedge funds are a vehicle designed to transfer wealth from investors to hedge-fund managers. Indeed, while running the D'Arcy Dynamic Returns Fund for thirty years, my original £1 million investment grows to a staggering £230 million. This is a compound return of almost 20% a year, which is wonderful for me, but terrible for my investors!
In summary, hedge-fund returns are vastly asymmetric, thanks to the fund manager taking such a large slice of the pie each year in annual and performance-related fees. This humble arithmetic is a powerful argument not invest in hedge funds, no matter how attractive their performance history.
> An index tracker is the cheapest, simplest way to capture the majority of the returns generated by UK-listed companies.
More ideas from Cliff D'Arcy:
