Streetwise for Friday, November 9, 2018

There is a continual inflow of letters asking about the efficacy of investing in what are called alternative investments as part of a diversification strategy, i.e., a strategy incorporating assets uncorrelated to other parts of a portfolio, specifically stocks and bonds.

Alternative investments are part and parcel of what is called modern portfolio theory. The category includes hedge and private equity funds. Up front let me say that I am not in favor of such investments, particularly for the average investor. And I am not alone.

Warren Buffett has long been a critic of so-called alternative investing, calling it, “A fool’s game.” One key reason is extremely high fees. The result is billions of dollars for the managers and far less for clients.

In a letter to Berkshire Hathaway shareholders. Buffett wrote that many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers who, in turn, recommend other high-fee managers, labeling it all a fool’s game.

The players in this “fool’s game,” include not only wealthy individuals but also mutual funds, pension funds, university endowments, foundations and even sovereign wealth funds managed on behalf of countries.

When talking about alternative investments, you are generally referring to hedge funds. So, what are hedge funds and why are they supposedly so popular?

The term “hedge fund” was first applied in the 1940s to alternative investor, Alfred Winslow Jones. He created a fund that sold stocks short as part of his strategy.

Today, hedge funds are privately-owned companies that pool investors’ dollars and reinvest them into complicated financial instruments in hopes of outperforming the overall market.

That of course is everyone’s goal. However, hedge funds believe they can create high returns regardless of market volatility. Possible but unlikely.

More than 8,000 hedge funds managed $2.8 trillion in 2014, according to HFR Inc., a subscription hedge fund reporting service. That’s triple the amount managed in 2004.

Although hedge funds did outperform the stock market for a period that included the financial crisis, that superior performance ended in 2009.

And of the new money invested, the super-large funds receive a disproportionate share. Approximately $75 billion was added to funds in 2014, of which 90 percent went to funds that managed $1 billion or more.

The smaller or start-up funds represent a considerably greater risk, with the result that 864 firms closed in 2014, averaging only $70 million each in assets.

Hedge funds are set up as limited partnerships or limited liability corporations that protect the manager and investors from creditors if the fund goes bankrupt. The contract describes how the manager is paid. It may sometimes outline what the manager can invest in, but often there are no limits and your funds cannot be withdrawn for a period of years.

Some hedge fund managers must meet a hurdle rate before getting paid their portion of the profits. The investors receive all profits until the hurdle rate is reached, then the manager receives a certain percentage.

Most hedge funds operate under the “2 and 20” rule, meaning they earn 2 percent of the assets managed and 20 percent of all profits after exceeding the hurdle rate, if there is one.

Recently, hedge fund clients have revolted. The poor performance and high fees have forced many hedge funds move to a more lenient scale of a 1.4 percent fee and 17 percent of all profits.

Hedge funds managers are only at risk for their percentage of their fund’s profits. If the fund is unprofitable, they still receive 2 percent of the assets managed. Therefore, they become very risk tolerant. Investors consequently could potentially see little or no return on their investment. They could even lose their entire investment.

If you are for some reason determined to investigate hedge funds for an investment vehicle, please read the SEC Bulletin on Hedge Funds. It offers up a primer on hedge funds, including how to choose a hedge fund manager.

Lauren Rudd is a financial writer and columnist. You can write to him at Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to