Ask Stacy: What the Heck Is a Hedge Fund and How Do They Work?

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When people on Main Street hear the word “hedge,” they think bushes. Wall Street types, on the other hand, might picture something entirely different.

Here’s this week’s reader question:

What is a hedge fund and how do they work? — Dee

Before I answer Dee’s question, take a look at this video I shot on Wall Street. It may help you invest the money in your 401(k) or other investment account.

What’s a hedge fund?

A hedge fund is an investment partnership. Limited partners put up money, and the general partner, also known as the manager, invests it.

The manager has very wide latitude when choosing how to invest the partners’ money. They can invest in securities, like stocks and bonds; physical assets, like office buildings and gold; or derivatives, like commodity futures and options. They often attempt to optimize their returns with sophisticated strategies and borrowed money, which is called leverage.

In short, the sky’s the limit. They can invest pretty much however they choose.

An easy way to think of a hedge fund is to compare them with a mutual fund. Like a mutual fund, investors pool their money, hire a manager, then own a commensurate share of a portfolio. But mutual funds typically have strict guidelines as to allowable investments. For example, they might invest only in the stock of big companies, or government bonds. Hedge funds, on the other hand, have much more latitude and often take much more risk.

The “hedge” in the name refers not to bushes but to having the ability to profit from both rising and falling prices, as in “hedging a bet.” For example, if you own a $100 million worth of real estate, you might throw a few million to a hedge fund manager like John Paulson, who made $15 billion in 2007 by betting against real estate. Then, if your real estate holdings drop, you’re potentially making up part of those losses with your hedge-fund gains.

Ready to play? Bring lots of money

Some mutual funds require minimum initial investments as low as $50. But if you’re thinking hedge fund, think six figures.

The minimum investment for hedge funds is typically at least $1 million.

And if you think your mutual funds charge too much in management fees, wait till you see the fee structure at hedge funds. According to The Wall Street Journal, the average hedge fund charges its investors 2 percent annually on money under management, plus 20 percent of profits.

A low-cost, low-minimum mutual fund like Vanguard’s S&P 500 Index Fund, on the other hand, has a minimum of only $3,000, charges 0.17 percent annually and gives all the profits to the investors.

To put that in perspective, if you invested $1 million with the typical hedge fund, and it made 10 percent in a year, you’d pay $20,000 as a management fee and $20,000 more as a percent of the profits, for a total of $40,000. For the same million, Vanguard would have charged only $1,700.

Obviously, no 1-percenter in their right mind would hand over the equivalent of a luxury car for investment management, unless justified by performance.

Or would they?

This isn’t how the rich get richer

In 2008, investing legend Warren Buffett made a bet with a hedge fund called Protégé Partners. The bet was for $1 million, and the rules were simple: If Protégé could beat the Vanguard 500 Index Fund over 10 years, Buffett would contribute $1 million to a charity of its choice. If not, it would contribute a like amount to the charity of Buffett’s choice. The bet started Jan. 1, 2008.

This should have been a cakewalk for Protégé. The Vanguard fund is completely unmanaged. It’s simply a basket of stocks designed to track the returns of the stocks of 500 large American companies. Hedge funds, on the other hand, are not only staffed by Wall Street’s best and brightest, they’re much more flexible. As I explained, they can invest in anything from complex derivatives to single-family homes. They can bet against the market and profit when stocks fall. They can use futures and options.

This should have been like betting on a 5-year-old in a fight with a professional boxer.

In this case, however, the boxer is so weighed down by fees that he can’t move. As of April 2016 (the most current data I could find) here is how the competition stands, according to Fortune:

The fund Buffett picked, Vanguard 500 Index Fund Admiral Shares (which invests in the S&P index) is up 65.67%; Protégé’s funds of funds — funds that own a portfolio of positions in a range of hedge funds— are up, on average, a paltry 21.87%.

The bet will formally end on Dec. 31 of this year.

What can we learn from this?

Hedge funds, at least taken as a whole, represent what could be one of history’s silliest examples of paying more to get less. If paying twice the price for a shirt because of a designer label is dumb, what should we call paying a manager $40,000 to radically underperform an unmanaged index?

Granted, there are hedge funds that trounce the S&P 500 and are well worth whatever outrageous fees their managers charge. But finding one would be like looking for a needle in a haystack.

Hedge funds are useful, however, when it comes to learning about all kinds of investing. Here’s what I think those lessons are:

  • It’s hard to beat the market. There are so many unpredictable variables affecting things like stocks that few people can consistently outperform the market, no matter how smart they are or what they charge.
  • You don’t always get what you pay for. Hedge funds not only charge ridiculous fees, you have to be rich before they’ll even take your money. Presumably, people who can meet million-dollar minimums aren’t stupid. But if they’re not, why are they paying so much and getting so little?
  • All hat, no cattle. Those in the business of selling their “expertise” want you to believe markets are far too complex to navigate without paying them — handsomely. Warren Buffett knows better. And now, so do you.

So, what do you think? Is Wall Street advice worth the money, or is it all just smoke and mirrors? Sound off below or on our Facebook page.

Got a question you’d like answered?

You can ask a question simply by hitting “reply” to our email newsletter. If you’re not subscribed, fix that right now by clicking here. The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get a lot more questions than I have time to answer.

About me

I founded Money Talks News in 1991. I’m a CPA, and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. If you’ve got some time to kill, you can learn more about me here.

Got more money questions? Browse lots more Ask Stacy answers here.

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