Are hedge funds for chumps?

Courtesy of the Associated Press

(c) 2013, The Washington Post.

I'm starting a hedge fund. Here's the plan.

You give me your money. Every year, I will take this money to Las Vegas at the beginning of football season and bet that some pretty good team will not win the Super Bowl. The Seattle Seahawks currently face 7-1 odds, and I don't really like the color of their jerseys, so I'll bet against them this year. Assuming Seattle does not win the Super Bowl, I should turn every $7 of my investors' money into $8, a whopping 14 percent return!

Even better, my ability to achieve that return is not affected a whit by whether the stock market rose or fell that year. In the world of investing, a "non-correlating" asset like my hedge fund is particularly desirable. You want things that zig when the rest of the markets zag, or at least where the zigs and zags happen randomly.

Now of course, I require adequate compensation for my labor. Suppose you and my other investors gave me $1 billion to "invest." I think I'll take 2 percent of that off the top, you know, $20 million in walking-around money. Then I'll take 20 percent of the profits I generate, another $28 million in this case. So I'm paying myself a handy $48 million a year before expenses for "managing" my investors' money. And suddenly your 14 percent return is actually more like 9 percent. Sorry, gotta pay the bills. Do you know what a Gulfstream jet and a house in the Hamptons cost these days?

But still, a 9 percent return! Non-correlating! Assuming the Seahawks don't win the Super Bowl, you might be so happy that you give me even more money next year. My fund, which I'm calling Strategic Capital Asset Management, looks like a great deal.

Now as a savvy investor, you may see the problem. It may look like I'm giving you a 9 percent non-correlating return, but SCAM is, well, just that. It's not a return I'm delivering thanks to some real skill, but through luck. I may well go many years generating a nice return, but eventually the fund will blow up and you will lose all your money. Of course, by the time that happens, I may well have recorded hundreds of millions of dollars in fee income which, if I'm smart, I've stashed in a diversified set of investments.

All of which brings us to the recent news surrounding the hedge fund industry. Bloomberg Businessweek's recent memorable cover announced that "Hedge Funds are for Suckers." (Check out that article as well as an excellent response from Josh Brown over at The Reformed Broker.) The article cites a range of data that show that hedge funds performed worse than the market as a whole in recent years, and that while some fund managers generate excellent risk-adjusted returns, you won't have much luck identifying those managers in advance. And last week, the Securities and Exchange Commission (SEC) approved new rules that will allow hedge funds to advertise to the public. (They are still allowed to accept investments from only "sophisticated" investors, those with a net worth over $1 million.)

So, just as there is broader recognition that you're probably not going to win outsize returns from handing your money over to hedge funders (outside, perhaps, of a few of the biggest and most established hedge funds, which as Brown notes are probably not interested in taking your money), there also is the possibility of a new wave of advertising that will likely aim to bring in new and less savvy investors.

The question is which of those forces will win out. Will the affluent doctors and lawyers and executives around the country with a couple million dollars in savings, who are newly pitched the chance to invest in hedge funds, believe that they are finally getting entree into the exorbitant returns previously enjoyed by the ultra-rich? Or will they read things like the Businessweek cover and understand that they're really signing up to support a money manager's luxury lifestyle while earning returns that, on average, will be a bit below those if they invested in plain vanilla stock and bond funds.

The key problem is that it is hard to know in advance which funds have some way of generating sustained profits and which are a more complex, sophisticated version of our SCAM fund that is built around betting against the Seahawks winning the Super Bowl.

Our fund isn't creating any real value; rather, it's a heads I win, tails you lose deal. The bet may work out fine this year, and next. But, eventually, my SCAM fund will bet against a team that goes on to win it all. And when that happens, you will lose all your money, but I will have collected many millions in fee income for managing your money.

Now of course, no hedge fund would announce to investors that it was pursuing a strategy of betting against a sports team winning a championship; it would be too obvious what the game was, and no one would fall for it.

But what many (not all, but many) funds do is a version of the same thing. They have elaborate strategies for picking stocks, bonds, currencies or derivatives of varying degrees of exoticism. They show off their proprietary algorithms and shiny trading floors armed with physics PhDs and hotshot traders. But it is exceptionally difficult for even sophisticated investors — let alone a dentist from Cleveland — to judge in advance which have come up with a brilliant and sustainable way to exploit true mispricing in markets and which are just a high-class form of gambler.

Which is why, when the hedge funds start advertising, the dentists in Cleveland, and anyone else with money they're looking to invest, needs to be wary.