Friday, February 13, 2015

Hedge Funds Underperform - Get More Money

A fascinating blog post in the Big Picture (you can read it here) refers to a clear under performance of hedge funds. Yet, these funds keep on attracting more funds. This is truly a paradox.

The Big Picture post refers to a Bloomberg article (this one).

The message is: in 2014, the hedge funds returned 3 percent while the S&P 500 returned 11 percent. Out of the 3 percent, you have to pay 2 percent of the funds as management fees, and then 20% of all gains. So, essentially, investors in hedge funds got nothing. Of course, the fund managers did get their 2 percent of total funds. (This is a lot of money. Suppose there is a small hedge fund that manages $500 million The managers will earn 2%, meaning $10 million for essentially giving a zero percent return).

It is not just 2014. The Bloomberg article points out that hedge funds have been consistent under performers over many years.

So, why do people give more and more money to these funds?

The author says: "The best answer I can come up with is that investors are irrational. Hardly a groundbreaking insight, I know, but it is the best explanation I’ve been able to reach. "

To me,the answer seems to be: superb marketing. There is so much money to be made in the shape of management fees that a full industry has sprung up, enticing investors to put money in hedge funds.

Most investors and traders have this secret desire for super normal returns. When someone promises such returns, they end up investing with that person.

I know this well! Often, on TV, I suggest not taking a trade because the outlook (to me) is not clear. No one likes this suggestion.

Most people in the financial services business are actually in the business of selling dreams. Very few traders and investors understand this.


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