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Investors Should Steer Clear of Hedge Funds, say Experts

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Individual investors should shun hedge funds. So says a revered group of economists.

The Financial Economists Roundtable (FER), which meets annually to discuss micro-economic policy issues, delivered its directive in a study it published on the Web site of the Stanford Graduate School of Business.

In its study, the FER acknowledged the heady increase in hedge fund investing in the past two decades. Today, hedge fund investing has grown to about one-eighth the size of mutual fund investing. The hedge fund industry now consists of more than 8,000 funds, which hold about $1 trillion in investments, concluded the FER.

But hedge funds, which are largely unregulated partnerships, pose some serious hazards to investors, especially retail investors, the FER said. Specifically, the FER is concerned about the high fees, inconsistent data and hard-to-understand risks that hedge funds pose.

“Their management expenses are very high and their investment strategies are often risky with a small possibility of very large losses,” the FER said. “This and other risks are not understood by all investors.”

Hedge fund expenses tend to be on the high side for a number of reasons. For one thing, the management fee to the general partner is usually 1% to 2% of assets, payable annually. In addition, there is often an asymmetric performance fee tacked onto the management fee. This fee, which is called the “high water marke” is paid by the investor for performance gains over a certain threshold, usually 20% of those gains.

Adding insult to injury, when cumulative returns fall below the high-water mark, the general partner can close the fund and establish a new fund in order to establish a new base mark for generating performance fees. “New investors overlook this exit risk,” FER’s report says.

On top of that, the asymmetric fee structure creates an incentive for the general partner to adopt a high-risk investment strategy. Indeed, he or she stands to make a large return if the strategy is successful, but not to suffer losses if the strategy fails.

The FER is also concerned about the inconsistency of hedge fund data available to investors. For instance, risk-adjusted average returns tend to be overstated because of survivorship bias and other reporting and data problems, making it difficult to compare hedge fund performance with competing alternatives, it says.

“The investor, particularly the retail investor and his/her agents, should be wary,” the FER warns. “Available performance data makes it difficult to judge true hedge fund returns and risk for this high-cost vehicle.”

As a result of these concerns and others, the FER recommends that fiduciaries carefully limit their investment in hedge funds. With the risks involved, the FER has concerns about whether a large exposure to hedge funds is appropriate for pension funds and other fiduciary investors who make investments on behalf of others, particularly retail investors.

The FER also recommends that regulators vow not to bail out hedge funds. “The prospect of free government ‘bail-out’ insurance creates adverse incentives for speculative behavior,” it says. “Expressing a ‘no bail-out’ policy would reduce those incentives.”

And, the report calls for the standardization of hedge fund performance and risk measurements. To that end, it encourages industry trade groups, like the Chartered Alternative Investment Analyst Association, to develop standards for measuring performance and risk for hedge funds.

Lastly, the FER calls for research on the asymmetric fee structure and its effect on investment behavior by hedge funds.