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Hedge Funds And Alternative Investments Are Too Complex & Costly For Mom And Pop Investors

June 18, 2014 Blog

Financial advisors with yield hungry clients have been pitching hedge funds and alternative investments to their retail customers. It turns out that hedge funds and “liquid alts,” as they are known, often aren’t what they are supposed to be.

A hedge fund’s purpose is to maximize investor returns and eliminate risk, hence the word “hedge.” The name “hedge fund” came into being because the aim of these vehicles was to make money regardless of whether the market climbed higher or declined. This was made possible because the managers could “hedge” themselves by going long or short stocks. Shorting is a way to make money when a stock drops.

Hedge funds are also meant for wealthy investors and institutions, who often can wait patiently for years for investments to produce returns. Hedge funds are also volatile because managers borrow to produce super-sized returns. Such borrowing, known as “leverage,” can also ramp up the risk.

Are such investments too complex and risky for the average Main Street investor?

Of course they are.

And do these hedge fund returns even deliver what investors are seeking?

Of course they don’t.

“Hedge funds haven’t done much for investors lately,” according to a recent report by Justin Lahart of the Wall Street Journal.

Lahart cites the HFR Hedge Fund Composite Index which showed back-to-back declines for March and April of this year and noted that equity hedge funds did not keep track with the S&P 500 returns. Equity hedge funds, which bet on and against stocks and invest in equity derivatives, had a particularly hard time, falling 1.2% even as the S&P 500 had a total return of 1.6%.

At the same time, according to the Journal, Institutional Investor’s Alpha report showed that the 25 highest paid hedge fund managers made $21 billion last year, “casting into stark relief hefty fees hedge funds charge.”

Wall Street has never had a problem with paying itself top dollar, but such largesse boggles the imagination. Why should a Mom and Pop retail investor buy a hedge fund with such hefty fees when one could simply buy a low cost mutual fund that tracks a stock market index?

And the shortcomings of the hedgies are nothing new, according to Lahart.

“Hedge funds lagging behind isn’t a necessarily new phenomenon,” he reported. “But it is a bigger issue as the amount of money in the vehicles continues to increase, in part because return-and yield-starved pension funds are embracing them in greater numbers. Hedge funds are now managing more than $2.4 trillion, according to HFR, versus $865 billion a decade ago.”

Another popular product that mimics hedge funds, “liquid-alternative funds” has exploded in popularity in the past year, according to the Journal’s Kristen Grind. Investors are pouring tens of billions of dollars into these high cost funds and many large investment houses regard the area as a growth business.

And if you’re an investment house like Goldman Sachs, what’s not to like?

Liquid alternative mutual funds had $40 billion in net inflows last year, according to the Journal. If pension funds are struggling with hedge fund returns, you can bet that bread and butter financial advisors are also having problems with these complex products that are extremely sensitive to movements in the broad stock market as well as any changes in interest rates.

According to Grind, leading financial advisory firms such as The Vanguard Group and Edward Jones are avoiding these fad investments because “they are complex, and some use leverage, or borrowed money to amplify returns, potentially adding to the risk involved.”

Other financial advisors characterized “liquid alts” as “like a black hole.” One advisor said, “I don’t buy something when I don’t understand what’s in them”.

Similarly, complex and opaque private equity investments are also being pushed on retail investors, according to a report from Bloomberg. The Carlyle Group, Blackstone and KKR are “among private equity firms that have sought to increase their appeal to ordinary investors with an eye to managing a piece of the $4.2 trillion Americans held in 401(K) Retirement Plans,” according to Bloomberg.

Are such complex and high priced products really suitable for the ordinary investor?

Financial advisors are pushing complex, high fee alternative investments on yield hungry retail investors who don’t understand what they’re buying. In many cases, the advisors don’t even understand what they’re selling.

Buyer beware of complex and expensive hedge funds and alternative investments.

Zamansky LLC are investment and stock fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.