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Hedge Fund Bubble

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You’re going to love this. Hedge funds had a terrible year. As of mid-December, the Dow Jones Credit Suisse Core Hedge Fund Index was off 8%. The index is an aggregate of funds using seven different hedging strategies: convertible arbitrage, emerging markets, event driven, fixed-income arbitrage, global macro, long/short equity, and managed futures.

Hedge funds are paid using a formula known as “2 and 20”—2% on assets under management (AUM) per year and 20% of profits. If you have a $10-million portfolio and a hedge fund loses 8%, you’re actually out 9.84% or left with $9,016,000 (8% loss on $10 million is $800,000, plus 2% fee assessed on the ending balance of $9.2 million of $184,000 equals a loss of $984,000 or 9.84%).

But here’s the rub. Check out what happens in a year of 10% gains. In my example, your $10 million grows to $11 million (yippee!) before fees (argh!). The hedge fund managers take their $200,000 or 20% of profits and$216,000 or 2% on AUM for a total haul of $416,000 or about half of your gains—an implied management fee of 3.8% on $11 million—leaving you with $10,584,000.

What tends to happen, at least recently, is that a hedge fund will string together a number of solid years of returns, grow assets, and then—whack!—will lose big-time. Portfolios can lose a quarter of their value literally in the blink of a few months. But get this: all the fees that were diligently paid by the client in the good times aren’t returned, even though the money is gone. There’s no clawback. And as is often the case, the fund closes and managers start a new one with a higher baseline.

If you’ve been a dedicated reader of this site, then you know not to buy into this stuff. Hedge funds and annuities charge some of the highest fees in the industry. What is a reasonable fee? How much is your time worth? You know how difficult it is to manage money effectively. As a point of reference, a fair advisory fee would be less than 1% per year on your assets. Clearly the hedge fund “2 and 20” bubble isn’t the answer—especially when it’s handily beaten by “boring” dividend-paying stocks.

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E.J. Smith

Editor-in-Chief
E.J. Smith is Founder of YourSurvivalGuy.com, Managing Director at Richard C. Young & Co., Ltd., a Managing Editor of Richardcyoung.com, and Editor-in-Chief of Youngresearch.com. E.J. graduated from Babson College in Wellesley, Massachusetts, with a B.S. in finance and investments. In 1995, E.J. began his investment career at Fidelity Investments in Boston before joining Richard C. Young & Co., Ltd. in 1998. E.J. has trained at Sig Sauer Academy in Epping, NH. His first drum set was a 5-piece Slingerland with Zilldjians. He grew-up worshiping Neil Peart of the band Rush, and loves the song Tom Sawyer—the name of his family’s boat, a Grady-White Canyon 306. He grew up in Mattapoisett, MA, an idyllic small town on the water near Cape Cod. He spends time in Newport, RI and Bartlett, NH—both as far away from Wall Street as one could mentally get. The Newport office is on a quiet, tree lined street not far from the harbor and the log cabin in Bartlett, NH, the “Live Free or Die” state, sits on the edge of the White Mountain National Forest. He enjoys spending time in Key West and Paris. Please get in touch with E.J. at ejsmith@youngresearch.com.