How Much Would You Pay For Promises?
ETFGI, an independent research firm focused on the global Exchange Traded Product (ETP) industry, reported that as of the end of Q1 2017 global ETP assets (which include ETFs) exceeded global hedge fund assets by over $800 billion.
This is a good thing. Mostly because it means hedge fund participation over the last two years has actually been declining.
What’s the problem with hedge funds? According to Wealthmanagement.com, two-thirds of hedge funds fail within three years of launch, and the ones that remain are expensive, opaque, and have spotty performance. From my perspective, though, it’s mostly the cost. As first reported in The Economist in 2005, a hedge fund is in reality “a compensation scheme masquerading as an asset class.” The average hedge fund charges 2% of assets plus 20% of profits. One on Long Island, according to The Economist, was reputed to charge 5% of assets plus 44% of profits, miles above the cost of the average publicly-traded mutual fund or ETF. Indeed, as I wrote in 2014, most of the earnings from hedge funds go to the fund managers, not the shareowners: Is That Hedge Fund Really Worth It?
Yet high net wealth (HNW) individuals and institutional pensions continue to hold about $3 trillion worth of assets in such funds. There must be some good reason. Perhaps it’s the unique strategies practiced by hedge funds? Some focus on absolute returns, promising consistency regardless of stock market behavior. Others promise amplified returns, typically by making big bets on illiquid investments in the hope of generating those outsize returns. Still others offer a hedge against market downturns by investing in non-correlated assets that mute returns during market upswings but provide a cushion during downturns. In reality, these promises are pretty much identical to the active management schemes promoted by many publicly-traded mutual funds, which you can buy at a fraction of the cost (and with better liquidity). You can even invest today (if for some reason you wanted to) in publicly-traded funds of hedge funds!
So what’s the hedge fund appeal? I can only conclude it is the result of very good (and very expensive) marketing. And possibly the snob-appeal mentality of exclusivity. The true cracks in the promises of hedge fund managers are unlikely to become more visible to everyone until pension fund managers stop relying on hedge funds to do their job of creating well-diversified investment portfolios. And that is starting to happen. CalPERS, the California Public Employees’ Retirement System, decided to divest its hedge fund investments in 2014, citing the cost. As the largest pension fund in the U.S., CalPERS’ action should serve as a wakeup call, not just to other pension funds but to all hedge fund investors as well.