Hedge Funds Aren’t Worth The Risk Part 3 – Poor Compensation Structure

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Though no accurate reporting exists, studies suggest that Hedge funds often under-perform traditional mutual funds. Part of the drag on their returns is a result of their structure compensating hedge fund managers better than hedge fund investors.

Hedge funds claim to seek a 6% to 9% annualized return regardless of market conditions. But their compensation structure encourages managers to seek their own compensation instead of smoothly appreciating returns.

In addition to higher than normal expense fees of 1% or 2% of assets, Hedge fund managers get paid a bonus for doing well, typically about 20 percent of profits. These performance fees are where the managers get their big bucks.

Hedge funds are highly leveraged, increasing the likelihood of potential windfalls but at the expense of the investor’s return to achieve them. They limit their downside risk by virtually guaranteeing a drag on the portfolio unless they hit it big. These large upswings are in the fund manager’s best interests, not the investors.

The fund’s strategy is to pay several percentage points buying options and other lottery tickets in the hopes of hitting it big. The expense of these lottery tickets is paid by the shareholders in typical performance, but a significant portion of any windfall is shared by the management as a bonus. To succeed, managers don’t need to be good; they just need to amplify the normal swing of positive and negative returns. This technique, while benefiting hedge fund managers, is exactly what shareholders are seeking to avoid.

There are also funds of Hedge funds that claim to provide better diversification and smaller minimums. These funds typically charge an additional 1% plus 10% of the gains bringing the total fees to 2% annually plus 30% of the gains. If you are not anxious to pay that level of fees, you have begun to understand Hedge funds better.

Hedge funds are illiquid, often locked up for the first four or five years with limited withdrawals after that. This is done, they claim, to protect the fund. In reality, rather than serving the best interests of the investor, it more often simply protects the fund against disillusioned investors from being able to get their money back.

If you determine that your fund managers are gyrating the account for their own performance fees, you are not allowed to take your money out and invest it elsewhere. By the time your waiting period is up, the damage to your investment is often complete and the fund is closing due to poor performance. Coincidentally, many Hedge funds close shortly after initial fund investments are allowed to be redeemed.

This explains why 10% of Hedge funds fail and close each year. After five years half of the hedge funds have great returns and half the hedge funds have dismal returns. Half of them fail when the investors are finally able to withdrawal their money after five years. Half of the hedge funds failing every five years results in an annual 10% failure rate. Investors in the other half believe that their particular fund manager must be brilliant when in fact he was just lucky.

Investors in successful hedge funds may get decent returns, but at the price of excessive risk for moderate returns. It is as though you are asked to place five bets on red at the roulette wheel. You take all the risk, but the manager gets twenty percent of any winnings. This is not a good compensation scheme.

At 4th of July cook outs, smoke often indicators a great meal. But when the lid is lifted on hedge funds, many investors ask, “Where’s the beef?” If you want A-1 on your steak instead of ketchup on your hot dog, we highly recommend the blend of tastes provided by a balanced portfolio. Your financial good health depends on it. The best financial chefs in America are Fee-Only investment advisors who will represent your best interests exclusively. To discuss the value of their services we would recommend setting up an appointment with the one nearest you by calling NAPFA at (888) 333-6659 or requesting the name(s) of the Fee-Only advisors nearest you through their website: www.napfa.org .

The short list of hedge fund problems thus far: higher than normal rates of closing down, heavier than normal fees, compensation schedules weighted toward encouraging their fund managers to take greater risks, often underperforming the market, illiquid and tax inefficient. There is one more item of concern to address before the list can be complete, their poor regulatory controls – next week.

Photo by Nathan Dumlao on Unsplash

Go to part:
  1. Hedge Funds Aren’t Worth The Risk Part 1 – What Are Hedge Funds
  2. Hedge Funds Aren’t Worth The Risk Part 2 – Poor Performance
  3. Hedge Funds Aren’t Worth The Risk Part 3 – Poor Compensation Structure
  4. Hedge Funds Aren’t Worth The Risk Part 4 – High Fees and Poor Regulatory Control
  5. Hedge Funds Aren’t Worth The Risk Part 5 – What Hedge Funds Do Right
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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.