Hedge Funds: Just Say No!

In this post, we review research on hedge fund performance. The results are eye-opening.

The first article is called “Buzzkill Profs: Hedge Funds Do Half As Well As You Think”. In this article on hedge funds, researchers found that average annual returns dropped from 12.6% annually to 6.3% annually after adjusting for biases. One primary issue that causes this incredible discrepancy is that hedge funds voluntarily report their results to the databases, and often present the data in the way that looks most favorable (yes you heard that right). In other words, when returns are poor, they can simply stop reporting their results.

In another article called Hedge Funds: What Are They Good For? the author says, “Absolutely nothing.” The article cites similar issues surrounding hedge funds, such as survivorship bias - which in this case, is centered around hedge fund returns only appearing in the databases if the funds did well. The funds with poor performance are removed from the databases.

The hedge fund database is also littered with backfill biases - meaning hedge fund managers will start a fund which is generally not available to the public and then wait to report the results once they are presumably favorable.

Another article is called Hedge funds: heads I win, tails you lose?. In this article, the author works through an example of how the math on hedge funds works using leverage. There is an incentive to leverage and take risks but no real penalty for downside risk.

The next video talks about Melvin capital and what happens if they have poor performance. I rarely watch CNBC but this is an incredible story about a hedge fund run by Melvin Capital and how they fixed their performance incentive. They just started a new fund (started over) with new performance incentives because it was going to take a long time to start earning their performance incentive on their current fund.

The next research is from a book is by Simon Lack called The Hedge Fund Mirage. The structure of management fees incentivizes hedge fund managers to take a lot of risk. They are paid a base of 2% of the total amount invested & 20% of the returns. Research by Simon Lack found that 86% of the returns went to the hedge fund managers. If you are thinking about purchasing a hedge fund, please give us a call.

If you are thinking about purchasing a hedge fund, please give us a call.

Robert J. Pyle, CFP®, CFA, AEP® founded Diversified Asset Management, Inc., in 1996 to provide personalized, comprehensive wealth management services to successful individuals, families, single women, and business owners. His specialty is addressing the complex financial needs of self-employed professionals, corporate executives, and small-business owners. Our disclosure can be found here. The views, opinion, information, and content provided here are solely those of the respective authors, and may not represent the views or opinions of Diversified Asset Management, Inc. Diversified Asset Management, Inc. cannot guarantee the accuracy or currency of any such third party information or content, and does not undertake to verify or update such information or content. Any such information or other content should not be construed as investment, legal, accounting, or tax advice.

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