"A Compensation Scheme Masquerading As An Asset Class"

Should you use hedge funds, or exchange traded replicators or avoid them both?

The title is a quote from a Bloomberg article about hedge funds, deriding the common 2 and 20 fee structure where 2 is the management fee percentage and 20 is the percent of the profit that goes to the managers. Many hedge fund investors don't actually pay that much but I only know that anecdotally.

Hedge funds have taken a reputational beating for collectively lagging plain vanilla equity index funds by a wide margin. You can click through to HFRI and see for yourself. One story I've told before, an acquaintance was invested in a hedge that made a killing by one way or another shorting the housing market in 2008, like 1000% killing. Years after the fact he told me that since that one year they hadn't really done anything, they were waiting for the next big event. I don't know whether the next big event has come yet or not but in the mean time they weren't really trying, still collecting the 2% or whatever (this was my acquaintance's perception of what was happening).

If you look at the list of indexes in the HFRI page you will see all sorts of strategies and I would think that within most of them, there will be some small number of funds that are killing it but most don't but that is not really what they are designed to do. You know this by what the asset class is called; hedge funds.

My understanding of them is that they have mostly evolved to seek return and volatility profiles that differ from the equity markets which is exactly what they have done. There are a few strategies that include the word arbitrage. I would not expect any sort of arb strategy to dramatically outperform an equity bull market. Some random fund might do it but expecting it probably doesn't make sense. Key to all these strategies (not just hedge funds but any type of alternative) is having the correct expectations.

All of that being said, I have no interest in using hedge fund for clients, the fees are difficult to justify (purely a subjective assessment, plenty of people think they are justifiable) and having to lock money up, access to the capital being restricted, is not something I want any part of. The strategies though to the extent they can be replicated in a brokerage account-friendly wrapper like an exchange traded product or traditional mutual fund does interest me, I have used a few of these over the years and currently many clients own the Merger Fund (MERFX) which is merger arbitrage and the IndexIQ Hedge Multi-Strategy Tracker ETF (QAI). Play around with the charts for these on Morningstar.

They look nothing like the stock market, kind of bond market-ish without the same type of interest rate risk even if QAI often includes bonds and usually better than market neutral. If they went up with the stock market I would be inclined to think they's fall with the stock market which is not what I am looking for with these holds. I believe they help with managing portfolio volatility.

If this sort of return profile doesn't appeal to you don't use them. If you think the fees are too much (they are expensive for funds but nothing like hedge-fund expensive) then don't use them. But if you are going to take the time to learn about these make sure you learn what expectations to have.

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