The Exchange

Hedge Fund Ads: Good for Them, Bad for You

By Roger Whitney

Now that the Securities and Exchange Commission has lifted a decades-old ban prohibiting hedge funds from advertising to the public, investors of the world have yet another temptation they'll need to avoid.

Although they're still limited to accredited investors, hedge funds will be able to promote their unconventional strategies on television, on the radio and in print media. This isn't cause for celebration.

Hedge funds are private investment vehicles that use sophisticated tactics and leverage in an attempt to maximize returns and protect principal. Most focus on providing an absolute return (that is, positive) regardless of market conditions, with approaches such as long/short, event-driven, global macro, market-neutral, relative-value arbitrage and other exotic names -- methods that simply aren't suitable for an everyday investor. That's why you have to be extremely cautious about doing any of these three things: Investing in them, investing like them, or investing in lower-priced products that imitate them.

While many individual investors aren't positioned to invest in hedge funds directly owing to the high cost, the lure to do as Bridgewater does may be strong indeed, and not only by way of mimicry. Access to these strategies has started to enter the mainstream in a very real way. Today, individual investors have the ability to get involved in an alternative asset or hedge fund-type of vehicle for as little as $50,000, with more of these perhaps on the horizon.

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Source: YCharts

Let them come, and let your intrigue end quickly. Chances are that neither hedge funds nor their methods are what you, or your portfolio, need.

Cults and complexities

In the last 15 years, institutions and the super-rich have piled money into hedge funds. The success of the Yale investment model popularized the heavy use of alternative strategies in asset allocation, and as a result, hedge fund assets grew sharply, from roughly $131 billion in 1998 to $1.64 trillion in 2010, by one measure. Earlier this year, the HFR Global Hedge Fund Industry Report said sector capital was even higher now, reaching $2.38 trillion in the first quarter.

The hedge fund arena is built on the cult of personality of its managers. George Soros, Bill Ackman and Steve Cohen have become billionaires and financial celebrities by placing big bets, using leverage and hitting it right, making for just the type of stories affluent investors (really anyone) love to be a part of and talk about. With advertising cleared to begin, we'll soon see promotions for complex strategies from funds that historically have been meant exclusively for a high-dollar chosen few willing and able to take the risk.

In a sense, this recalls the sea change that came with ads for prescription medicines, such as Lipitor and Celebrex, a few years back. Now they're all around us. As was the case with those drugs, there's a lot of money at stake for the hedge fund industry -- ultimately, billions will be spent to market its promises. And, akin to the cholesterol-fighters, there's little doubt investors will begin to ask for hedge fund strategies by name.

Resist that urge. Most everyone should limit, or entirely avoid, the ownership of hedge funds and the employing of their strategies. Here's why.

Performance: Although some individual hedge fund managers have turned in incredible performances, the HFRX Global Hedge Fund Index has significantly underperformed most equity indexes.

And it still could be overstated.

The HFR database, which is used to calculate index returns, is self-reporting. That means it only receives performance data from hedge funds that choose to supply it. Since poor-performing funds could choose simply not to report, the returns displayed may not provide the true, complete picture.

Junk food: A proven nutritional rule is to eat real food, not food product, and the same goes for investments. Hedge funds are the junk food of the investment industry. They use ingredients such as leverage, derivatives and esoteric trading strategies to attempt to create a good experience. The packaging is attractive, and it can taste good in small doses, but the fine print is impossible to understand.

The hedge fund way introduces risks that can't always be identified until things go wrong. It may work for a while, but the potential side effects can range from poor returns to a massive meltdown.

High fees: The standard hedge fund carries an annual fee of 2% of assets plus 20% of profits earned. To put it in perspective, the average fee for a large-cap mutual fund is 1.31%, and for a large-cap exchange-traded fund it's 0.47%.

What type of return would be required for you to feel good about this compensation plan for your hedge fund manager? In 2011, each one of the top 25-earning managers made $576 million, on average.

Hedge funds aren't only unorthodox in how they deploy your money -- they're also not cheap to stay in.

Protecting yourself

The purpose of investing is to preserve and grow assets, over time, in order to help achieve the things you care about. Too often, this is forgotten. It's human nature to want to “beat the market,” and hedge fund advertising will play on that desire.

The fact that these funds are unconventional and sophisticated is both good and bad. The bad is clear, and that's the part for individual investors to remember -- higher fees, the potential to perform poorly vs. the market and the significant risks due to the use of leverage and derivatives.

Keep that in mind when you're watching the happy faces of the actors in the ad blitz that's coming. Hedge funds and their strategies may have a place in some portfolios, but for most investors, they don't.

Roger Whitney, CFP, CIMA, CPWA, co-founded WWK Wealth Advisors, a Registered Investment Advisor, in Fort Worth, Texas. He has specialized in investment management and planning for 23 years. He's on Twitter @roger_whitney.

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