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Beware of Hedge Funds Bearing Gifts

By on May 13, 2011
Categories: FINANCIAL PLANNING

A recent article in the Wall Street Journal drew four lessons from the conviction of hedge fund manager Raj Rajaratnam, on insider-trading charges, that resonate with our investment philosophy at Dowling & Yahnke.  The first is that hedge funds don’t necessarily deliver superior performance.  In fact, over the last five to ten years most have trailed the performance of a balanced portfolio of index funds.  That active management underperforms passive approaches is a fact our firm has long known.  In the wake of this trial, we now know that at least one of the few active managers who has managed to beat the indices, did so via illegal means.   The second lesson drawn in the article is that fund fees matter.  Hedge funds are amongst the highest cost investment vehicles.  They generally charge a base fee of 2% of assets plus a performance fee of 20% of portfolio gains.  This is a high hurdle to beat if the investors in the fund are going to come out ahead.  The need to generate outsized returns in order to justify their high fees probably played a role in encouraging some hedge fund managers to break the law.  The third lesson falls under the heading “if it sounds too good to be true, it probably is.”  History shows that very few managers can deliver extraordinary returns and even fewer can do so consistently.  As in the case of Bernie Madoff, no one can legitimately produce a steady stream of 1% returns each month, month after month, year after year.  Finally, for those who are tempted to pick their own stocks rather than buy a passive fund, the fourth lesson is that you are unlikely to have an edge over professional investors, even those who are not acting illegally.  You can read the full article here: http://online.wsj.com/article/SB10001424052748703730804576317433897512992.html

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