Daily Capital

Better To Work For A Hedge Fund Than To Invest In One

The California Public Employees’ Retirement System, the second largest pension fund in America, recently decided to divest its entire $4 billion from hedge funds after spending $135 million in fees for only a 7.1% gain in 2013.

There are two shocking statistics here: 1) $135 million in fees on $4 billion AUM = 3.4% and 2) The S&P 500 returned 32% and outperformed CalPERS’ hedge fund performance by an astonishing 25%.

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Such drastic costs for such poor performance really underscores the futility in trying to outperform the index. Hedge fund managers are supposedly some of the brightest minds on Wall Street. But it’s safe to say that paying outsized fees for mediocre performance is not a great way to build wealth. In defense of hedge funds, hedge fund performance should underperform the S&P 500 during a bull market by nature of its hedging strategy. But hedge funds faired no better during the financial crisis either.

If you want to invest in a hedge-fund and don’t have the $1 million dollar typical buy-in fee (probably much lower for the really underperforming ones), you could buy the hedge fund ETF, HDG, which tracks a basket of the largest hedge funds in the world. But since HDG’s formation in late 2012, the index has done nothing but underperform the S&P 500 index (blue line).

hedge fund performance

It’s much better to work for a hedge fund and earn the typical 2% AUM fee plus 20% of profits, than invest in a hedge fund. Once you get to a large enough size, a good strategy as a hedge fund manager is to simply go market neutral or hug the index so that performance is never too out of line. A 2% fee on $1 billion AUM is still $20 million a year even if you provide 0% return. Now imagine if you grow your hedge fund’s size to $10 billion or more. Lamborghinis for all!

Focus on asset allocation based on your individual risk tolerance rather than trying to beat the market. There are more fun and rewarding things to do with your time.

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The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

Sam runs the Financial Samurai blog. All opinions reflected in this article are his own, and do not reflect the views of Personal Capital. He worked in finance from 1999-2012 before deciding to focus full-time on his online endeavors - FinancialSamurai.com and the Yakezie Network. Sam is an avid tennis fan who loves to travel. He received his BA from William & Mary and his MBA from UC Berkeley.
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