There’s no problem with investing in hedge funds – if you have $20 million. But if you are a regular person or even just rich, then hedge funds are a terrible investment idea.
The principle behind a hedge fund is sensible. Very wealthy, very sophisticated investors (usually foundations, universities, and other institutions, rather than individuals) make big long-term investments. Through hedge funds they can balance their investment portfolio with a very long-term view, thus avoiding some of the ups and downs that we mere mortals experience. Hedge funds provide these steadier returns by making large investments (which you and I might call “bets”) on sectors of the economy. The hedge fund usually balances this with another investment that is more or less the opposite of that first investment. Thus, the fund does OK regardless of what happens. It makes its money because it makes huge investments and does not have to worry about all the costs associated with having lots of small investors – like thousands of monthly or quarterly reports, toll-free hotlines, marketing expenses, and mom and pop asking for their money back when the market dips a little bit.
But while hedge funds were created to be safe, many funds had a great run of performance when the stock market did poorly in the early 2000’s. They outperformed the market by a ton, and it continued as the market went up-and-down in the past couple of years. But hedge funds only look good when the market is falling or very volatile, because they are designed to be stable and to take advantage of everyone else’s volatility. Those days have now passed, in large part because everyone is starting hedge funds and pursuing the same investments. So what the funds used to be able to do cheaply, doesn’t come as cheap any more.
I haven’t even touched on the worst parts about hedge funds, which are the obscene profits that they pay out to their managers. These profits come directly out of the pockets of the investors, who apparently don’t mind. Would you give 20% or more of your profits each year to some Wall Street guy? I doubt it – you complain about paying only a little bit more than that in taxes, and at least you get tons of government services for your tax dollars.
Anyway, don’t fantasize about getting into hedge funds. And definitely don’t buy mutual funds that pursue hedge fund strategies, or buy these stupid hedge funds that are now trying to sell shares to the public. You will just wind up being the latest sucker at the end of the line on an investment boom.