hedge funds soliciting customers through junk mail, cold calls, billboard displays and magazine ads. And who knows, maybe during Super Bowl commercials.>
Thanks to recent legislation changes, theU.S. Securities and Exchange Commissionwas forced to lift an 80-year-old prohibition on hedge fund solicitations and advertising.
This ability to advertise is a sea change for hedge funds because these investment managers have traditionally operated in secrecy. But now hedge funds, if they so choose, can advertise just like other financial institutions and the makers of Tide detergent, Cheerios and Dodge trucks.
While controversial, the issue of allowing hedge funds to advertise or not is now a moot point. What’s important is to approach these types of investments with a very high degree of skepticism if you are eligible to invest in them.
To qualify, you must be a so-called “accredited” investor. To meet that definition, you need to earn at least $200,000 per year or have more than $1 million in net worth excluding a family home. The federal government set this requirement way back in 1982 in an attempt to allow only “sophisticated” investors, or at least those who could afford to lose a significant chunk of change, to invest in hedge funds.
The following are four reasons to keep your distance from hedge funds:
Hedge-fund fees typically start with an annual investment fee of 1.5% to 2%. To put that figure into perspective, the annual expense ratio for the Vanguard Total Stock Market Index Fund, one of the nation’s most popular mutual funds, is 0.17%. Hedge-fund fees, however, don’t stop there.
If the hedge fund enjoys a profit, the managers may siphon off 20% of it. Hedge funds may also have high transaction costs and throw off income that is taxable at ordinary rates.
Many people assume that hedge funds produce incredible returns, but it’s often not the managers’ investing acumen that has blessed these financial professionals with great wealth; it’s the proceeds from those high fees.
For all the hype, hedge funds have been poor performers. During the past 10 years ending in 2012, the hedge fund index only beat the Standard & Poor’s 500 Index in one year.
Many hedge fund investments lack transparency about what the manager is investing in, which could include complex financial instruments such as derivatives. A key to executing an effective investment strategy is having a clear understanding of each asset in your portfolio and how it works together with other assets in achieving your long-term goals. Make sure you clearly understand what you are putting your money into before you pull the trigger on any investment.
You can’t expect to pull your money out of a hedge fund whenever you please. In some cases, it could take a significant period of time before you are permitted to withdraw your investment in a hedge fund.
My favorite observation about hedge funds comes from Eugene Fama, a brilliant economics professor at the University of Chicago, who recently won the Nobel Prize in Economics. (See the link to post about his win below.) I was attending an investing conference in Los Angeles years ago when someone asked Fama his opinion of hedge funds.
Fama’s response was, “If you want to invest in something where they steal your money and don’t tell you what they’re doing, be my guest.”