Why the mass affluent should avoid hedge funds

By Felix Salmon
September 16, 2011
post on Anthony Scaramucci.

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A fund-of-funds manager emails to take exception to my post on Anthony Scaramucci. “Your piece definitely has a negative bias,” he writes (guilty!), before adding:

I also take exception with your point that the mass affluent shouldn’t be able to invest in hedge funds. why not? 90% of active mutual fund managers underperform each year. these funds are 100% long in all market scenarios. Why is that good for the mass affluent—or anyone else for that matter?

I’m certainly not saying hedge funds are a panacea for underperformance. But there is no shortage of excellent hedge funds to choose from and I see that many now come in registered vehicles, offer daily NAVs and daily liquidity just like a mutual fund. if one can avoid the gambler, speculators and pretenders, I would think a hedge fund option for the mass affluent actually makes a lot of sense.

I think this is simply false. Let’s grant, for the sake of argument, that “there is no shortage of excellent hedge funds to choose from”. It’s a long, long way from there to saying that there’s any overlap at all between the set of excellent hedge funds, on the one hand, and the set of funds which come in registered vehicles and offer daily NAVs and daily liquidity, on the other. In fact, I feel quite comfortable in saying that no excellent hedge fund offers daily liquidity. If you can name one, do let me know. But so far it seems to me that funds offering daily liquidity are generally small, untested, and dangerous.

Even if my correspondent is right, then, that a hedge fund option for the mass affluent makes sense in theory, he still runs into the problem that it’s actually impossible to “avoid the gambler, speculators and pretenders”. Investing in hedge funds is really difficult — very few people are good at it, and doing due diligence on hedge funds is an extremely expensive and time-consuming process. It’s something that a mass-affluent investor is utterly unqualified to even attempt.

In general, fund of funds are sold, not bought. Insofar as they’re available to the mass affluent (however that’s defined), they’re generally made available by brokers working for the likes of Merrill Lynch or Morgan Stanley. Those brokers phone up their millionaire clients, and persuade them to put some portion of their money into a fund-of-funds of some description. Sometimes, as in the case of Fairfield Greenwich and other Madoff feeder funds, the fund-of-funds should properly just be called a fund-of-fund.

And of course it goes without saying — because it’s almost never openly discussed — that the reason brokers are so keen to pitch these products is that they get whopping great commissions for doing so. As a result, the funds that mass-affluent investors buy into tend to be the ones which are most generous to brokers, rather than the ones which might objectively be the best.

On top of that, the brokers themselves, even if they’re not driven by commissions, have no real ability to do due diligence on the funds or fund-of-funds that they’re recommending. Indeed, I’m not sure that anybody has worked out a way of doing thorough due diligence on a fund-of-funds.

More generally, there has been no remotely reliable study, as far as I know, of the relative merits of mutual funds as opposed to hedge funds accessible to retail investors, when it comes to returns either risk-adjusted or nominal. Quantifying the ability of mutual funds to beat the market is hard enough, given survivorship bias and other problems in measuring the universe. For hedge funds, it’s much, much harder, since there’s no public listing of the total returns of these things, especially net of fees, and it’s pretty much impossible to find third-party verification of hedge-fund returns.

Yes, mutual funds are 100% long in all scenarios. The alternative is that they become market timers, which is very hard and prone to going disastrously wrong. But if you are going to become a market timer, it’s far from clear that the best way of doing that is to invest in hedge funds, rather than just investing more or less money in stock-market index funds, depending on whether you think they’re overvalued or not. Hedge funds might be smarter, but they’re also more expensive. If you don’t have the resources to do a deep dive into the fund in question, working out whether it’s a good bet compared to its peers, then you’re better off steering clear of the asset class altogether.

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