Debunking Common Myths about Hedge Funds
Before you invest your money in a big and glamorous hedge fund, a little skepticism is in order. The following myths are the ones you’re most likely to hear.
Alpha is real and easy to find. Alpha is performance added from the portfolio manager’s skills. Each hedge fund has its own way of achieving alpha, and fund managers love to talk about it. Yet the market is so huge and so efficient that no fund can get a consistent advantage over it. If alpha does exist, it can be positive or negative. In other words, the fund manager could be subtracting value from the fund rather than adding it.
Hedge funds are risky. A common perception is that hedge funds are wild and crazy investments. Although some managers run hedge funds to maximize investment return relative to market performance, others design funds to generate returns within a narrow band — say 7 to 9 percent — by eliminating market risk.
The sole purpose of hedge funds is to hedge risk. You can’t make the assumption that an investment partnership called a hedge fund actually hedges. The first hedge fund had a unique business structure and a unique investment strategy: It was a private partnership that charged a management fee and a 20-percent bonus paid out of performance. It also hedged risk by buying securities it expected to go up and selling short shares it expected to go down. Nowadays, investment partnerships that call themselves hedge funds keep the business structure but not necessarily the hedging strategy.
The industry is secretive and mysterious. In exchange for their relatively light regulation, hedge funds agree to market only to accredited investors. Any activity that resembles marketing to unaccredited investors can bring a fund major trouble with the U.S. Securities and Exchange Commission, whether or not the fund is registered.
The hedge fund industry loves exotic securities. Not all hedge funds follow the strategy of investing in offbeat securities that most investors won’t touch. Many invest in traditional assets, like common stocks of large companies and U.S. treasury bonds — the same assets that an average mutual fund or average trust fund focuses on.
Hedge funds are surefire ways to make money. Hedge funds are like any other type of investment: Some do well, and some don’t. The label of the investment has nothing to do with its performance. And the stark reality is that many hedge funds don’t perform well.
Hedge funds are only for the big guys. Even smaller investors can apply some of the tactics hedge funds use by investing in funds of funds, which enable smaller investors to buy into a portfolio of several hedge funds, or by investing in mutual funds or exchange-traded funds that sell stocks short to benefit from down markets, just as traditional hedge funds do.