The Flaws of the Hedge Fund Strategy

The flaws of the hedge fund strategy have received wide coverage as both politicians and the media have attacked these vehicles. While some of these criticisms are unfounded, hedge funds are not without negatives aspects that you should understand. Ranging from the moral hazard to the lack of transparency, some of these concerns are legitimate. Regulators have attempted to affect change in the industry, but many of these attempts have fallen short of real reform.

What is a Hedge Fund?

One of the problems that you run into making comments about hedge funds is that the term covers a lot of ground. At the most basic level, a hedge fund is an investment vehicle that is allowed to take short positions. A hedge fund may have a short position because it believes that the asset is overvalued, or it may be hedging another position. Hedge funds have strategies that range from the vanilla to the wildly exotic, and the amount of risk they take varies significantly.

Another major feature of hedge funds is their typical fee structure. Most charge you a 1% management fee and a 20% performance fee. The management fee is levied against all of the assets in the fund, while the performance fee is charged against any positive performance. Under the performance fee, if the fund earns $50 million, then investors take $40 million and the managers keep $10 million. The high-water-mark feature means that a hedge fund will only charge fee on performance once – if it loses money. It must make that money back before new fees are charged.

The Flaws

The strongest opponents of hedge funds argue that the fee structure is a flaw. If you participate in the upside of performance, but do not participate in the downside, you are incentivized to take unnecessary risks. The short-term impact of this type of risk taking is that you can earn big returns for a number of years, but eventually a particularly bad year will occur. When this happens, investors lose money and hedge fund managers keep the money they made in earlier years. In many cases, knowing that they will have to earn back all of the money that was lost before new fees can be earned, these managers will close their funds. The same managers then open new hedge funds. If you invest in the new fund, you will pay incentive fees again because the new fund is not subject to the old high-water-mark.

The other major flaw with hedge funds is that there is a significant lack of transparency. Investors are unable to monitor the risk being taken with their money and, therefore, have no real idea what their position is between reporting periods. By the time you receive a quarterly report that tells you the hedge fund has lost a significant percentage of its assets, it is too late to react. If you are able to monitor your money on an ongoing basis, you are more likely to be able to protect yourself in extreme situations.

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