The problem with investing in hedge funds

By Felix Salmon
September 16, 2010

I had a fun time last night sparring with Cathleen Rittereiser, who brought along a couple of copies of her new book, “Top Hedge Fund Investors.” (Wiley, $60, but only $37.80 at Amazon.) Her elevator pitch was a good one: a lot of books have been written about top hedge fund managers, but this is the first to be written about the people who actually invest in hedge funds.

It turns out, however, that fund-of-funds managers and their ilk are even more secretive than hedgies. Even Rittereiser, who wrote this book in between stints working for various hedge funds herself, didn’t manage to extract any quantitative information about their performance: her criterion for being considered a Top Hedge Fund Investor is simply having been around a long time, or being responsible for lots of money. Or, I suspect, just being willing to talk at all.

This is my biggest problem with alternative investments in general, and hedge funds in particular. Think about the situation with mutual funds: people don’t feel qualified to pick stocks, which is reasonable, and so they get a mutual fund manager to pick stocks for them. Except there are just as many mutual funds as there are stocks, and it’s actually harder to pick a good mutual fund than it is to pick a good stock.

The problem is even worse with hedge funds, because they’re so secretive. If you want to invest in hedge funds, how can you get a good impression of what your options are and which is best? It’s very, very difficult. And so you turn to a fund-of-funds manager. But how do you pick them? It’s even harder.

As far as I can tell, the main way that people end up investing in hedge funds is that their private bank is also a prime broker for various funds. And so the two arms shake hands, as it were: the private-bank clients get introduced to the prime-brokerage clients, and money ends up flowing from the former to the latter.

That’s all well and good, but in an era when prime brokerages compete for hedge funds by extolling the depth and wealth of their private-banking client base, said client base might want a bit more objective advice as to who they should be investing with. Including, of course, unaffiliated funds.

It’s easy to go wrong in hedge-fund investing, either by putting money into a fund which blows up, or by diversifying into so many different funds and strategies that you end up diversifying away all your alpha as well. And paying a management fee to a fund-of-funds investor only makes it even harder to get any financial benefit out of investing in hedge funds.

My feeling is that most individuals who have done very well out of investing in hedge funds have done so mainly by luck: by knowing the right person at the right time. A few top endowment heads and the like know the lay of the land quite well, and have access to just about any fund they want. But unless you’re running a multi-billion-dollar endowment, and being paid a lot of money to do so, it’s hard for me to see how you can successfully invest in hedge funds through anything other than luck.

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