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Hedge Fund Expenses: They’re Not Cheap

One of the articles submitted this week to my roundup was an interview with a fellow who works as the co-manager of a new micro-cap value hedge fund. After taking a look at the fund, I thought I’d use it as an example of why I suggest that most investors stay away from such investments.

But first, let’s dispel a myth. One of the reasons commonly given for not investing in hedge funds is that they’re high risk. That’s not necessarily true. As with mutual funds, there are many different types of hedge funds. Some invest in high-risk assets; others invest at the low-risk end of the spectrum.

My primary reason for steering investors away from hedge funds is the same as my reason for staying away from any actively-managed fund: High costs. And, with hedge funds, boy can they be high!

“2 and 20”

The typical hedge fund expense structure is the “2 and 20” model, whereby the fund charges an annual fee of 2%, plus 20% of any gains. This is, as you might imagine, quite the hurdle to clear.

Very few investors have shown an ability to consistently outperform their passive benchmark by more than 2% per year, as would be necessary to justify the use of such a fund in place of a low-cost index fund. (In fact, because of the 20% performance fee, they’d have to outperform by well over 2% per year.)

A Low-Cost Hedge Fund?

Interestingly, this particular fund from the interview actually had much lower costs than many hedge funds:

  • It charges no flat annual fee,
  • Its performance fee is only calculated on returns above 6%, though it’s calculated as 25% of those returns, and
  • Its losses are carried forward to offset future gains prior to any fee being paid.

In short, as hedge funds go, this is actually fairly reasonable.

Still, it’s anything but low-cost. By way of illustration, if a small-cap value fund with that expense structure had simply tracked the results of its index over the last ten years, here’s how much it would have charged per year:

  • 2000: 3.72%
  • 2001: 1.76%
  • 2002: No fee.
  • 2003: 3.77%
  • 2004: 4.43%
  • 2005: 0.07%
  • 2006: 3.36%
  • 2007: No fee.
  • 2008: No fee.
  • 2009: No fee.

Even with four years out of ten having no fees at all, such a fund would still have been charging more overall than the typical actively managed small-cap value fund, which in turn would be charging far more than a good, cheap index fund.

Given the usefulness of expenses as a predictor of performance,  I’d suggest that most investors stay away from any investment that promises to take such a large share of your returns.

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  1. You may know of low risk hedge funds-I don’t but I don’t follow them that closely. One of the problems is the they are typically anything but hedge funds. Most in fact take real aggressive bets.
    It seems to me that the only reason to consider their fees is in expectation of outrageous gains. And many hedge funds have had excessive gains but typically they run into rough waters. The best example of course is Long Term Capital Management (the largest hedge fund in the country at their peak) which had such good performance they had to turn money away in early 1998. By the end of the year they were out of business and needed a Federal Reserve engineered bailout to prevent big losses to U.S. banks (where have we seen that before?).
    A really great read on this is “When Genius Failed” by Lowenstein.
    A big problem I have with hedge funds is that you typically are buying into a “black box” approach. You can’t tell what they hold.

  2. Good article by Burton Malkiel from Princeton a few years ago looking at the performance of hedge funds and basically concluding that after accounting for survivorship bias, it’s best to stick with index funds over hedge funds.

    Unfortunately a lot of investors don’t like things that are “boring” like index funds and instead try to go for the hot investments and get burned (pun intended).

    Good post!

  3. How many of your readers (or in reality ANY American based blog) are even allowed to get involved with hedge funds?

  4. I assume that’s a rhetorical question, as no blogger or publisher would have any way to know that.

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