What if you were invited to be part of a coveted and exclusive investment group? Would you accept the invitation? In most situations, you probably would and it could possibly be a wise move. But, in the world of investing and hedge funds, it would likely not be a choice consistent with your goals and values.
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While being part of a select group of individuals sounds enticing, paying 2% fees each year and 20% of your profits doesn’t sound as pleasurable. If you had a million dollar portfolio that returned 10% next year, you would pay $40,000 in fees. Compared to an independent advisor who offers investment management coordinated with tax planning and retirement planning, the fees would likely be closer to $10,000. Usually you pay for quality, but in this situation, the exorbitant fee charged by a hedge fund does not necessarily translate to higher quality.
As mentioned in the article referenced above, not only will the fees drag on your return, you often receive no comprehensive wealth management advice as well as lower returns. Hedge funds are free to invest however they desire, which often results in very complex trading strategies. While the investment pitch sounds great: consistent returns with little downside risk, in practice, it can mean severe underperformance compared to a globally diversified portfolio.
Some hedge funds do very well indeed. But a major issue for you as an investor is identifying the winners before they are winners. Managers may get lucky and have stellar performance and then the fund will see large inflows. Thereafter, the returns will decrease. Who wins in this scenario? Not the investor who is saddled with lower returns. Rather, it is the famous hedge fund manager who is consistently earning 2% on your assets each year and 20% of the profits. Further complicating the matter is that the few fund managers who have long records of outperformance generally close their funds to new investments, taking the best options off the table.
Investing in hedge funds might seem like an exclusive party, and in all reality, it is a selective party open only to accredited investors. U.S. laws prevent people with less than $1million in net worth (excluding their home) or making less than $200,000 a year from investing in hedge funds. Even if you fall into the camp that could gain access, it may well not be a party you want to attend. To compare investing to ice cream, in this case, plain vanilla should be the preferred flavor over the chocolate-fudge, raspberry-filled, sprinkle concoction that looks pretty, but will ultimately leave you feeling queasy.