"I would never join a club that would have me as a member." Groucho Marx
Hedge Funds & Alternative Assets –Unattractive for Most Investors
One of the services most frequently touted by private wealth managers is their ability to provide access to outstanding alternative assets like hedge funds. Unfortunately very few private wealth managers have access to the hedge funds that are worth the fees. Of course, that won’t stop them from promising you the best and delivering poor alternatives. That’s why David Swensen, Yale’s Chief Investment Officer and the man most identified with employing alternative assets, essentially says in the introduction to his groundbreaking book Pioneering Portfolio Management, that if you can access premier alternative assets like hedge funds, you should, but it’s highly unlikely that you can, so you shouldn’t.
Understanding Risk and Reward
As we have explained many times in this blog, returns tend to be correlated with risk. Higher returns usually can only be achieved by taking on more risk.
Another way to think about this is manager selection makes very little difference at the low end of the risk scale (the left side of the graph), but makes a big difference at the high end. Persistence among the top performers also increases -- a common characteristic of the best performing managers is their desire to limit the amount of money they manage. The less successful managers are willing to take as much capital as they are offered. There is a very good economic justification for this behavior. The best managers of alternative assets are paid a management fee equal to 1% to 2% of the assets they manage and 20% of the profits. If you are confident in your ability to generate outstanding returns (which are typically predicated on limiting the amount of money you manage) then you can earn far more on your percentage of profits than management fee. If you’re not confident in your ability to generate great returns then you want to maximize your capital under management to maximize your management fees. Not surprisingly the best managers are heavily oversubscribed which allows them to be very choosy as to which investors they wish to take. Therefore access is of critical importance.
Not All Investors Are Equally Attractive
From the hedge funds’ perspective, university endowments are typically viewed as the ideal investor because of their sophistication and very long-term investment horizon. The worst possible clients were individual investors, typically aggregated by private wealth managers. Individuals are viewed poorly because they typically have the shortest time horizon and are inappropriately spooked by short-term negative results (i.e. they attempt to time the market).
I hope you see where I’m going. The only alternative asset managers who would accept money from private wealth management firms are typically the poor performers or the desperate. I think Groucho Marx captured the appropriate perspective for an individual investor reviewing alternative assets when he famously said “I would never join a club that would have me as a member.”
Superior Risk-Adjusted Returns Compared to Hedge Funds
Unfortunately, the typical results for hedge funds support Groucho’s sentiment. The average hedge fund as measured by the Hedge Fund Research Index (HFRI), which covers 2,000 self-reported hedge funds, had a ten year average annual return of 3.02% as of May 31, 2015. By comparison the TWM “Target 50” model portfolio comprised of 50% stock and 50% bond market indexes returned 8.72% over the same period.
The advantages of the TWM model allocation portfolio become even greater when you add in the incremental benefits of taxes. Hedge funds raise the majority of their money from tax-exempt entities like university endowments, charitable foundations and pension funds. As a result they pay far more attention to their pre-tax return than their after-tax return. Their high portfolio turnover rates leads to the recognition of significant short-term capital gains which are taxed at the highest state and federal tax rates.
In contrast, TWM uses an index-centric fund approach, which has very low turnover, and generates comparably limited short-term gains. In addition, TWM uses tax loss harvesting and asset location to squeeze out additional returns.
The Perils of Fund-of Funds
To be fair our analysis compares a model portfolio to an average hedge fund. Tthe top-performing hedge funds can offer stunning returns as compared to the industry mean. However, the top-performing hedge funds are incredibly difficult to access. Many private wealth management firms address this marketing challenge by investing in fund-of-funds that might get access to at most one or two top-performing hedge funds. Unfortunately the remaining 90 – 95% of the fund is usually filled with funds you really don’t want to own, but the only funds that are discussed in the sales process are the outstanding one or two firms. In this way many unknowing investors are hoodwinked into investing in what usually turns out to be a lousy-performing hedge fund fund-of-funds.
You Are Not An Endowment. Avoid the Fees on Mediocre Alternatives.
An investor worth several million dollars likely thinks of herself as an exceptional success, and financially, she is. However, if you don’t have at least $50 million to invest and are really well connected then it’s highly unlikely you will have access to the premier hedge funds.
The next time you get a pitch to invest in hedge funds, be very circumspect. It’s highly unlikely you’ll receive access to anyone in the top quartile, but that won’t stop the sales pitch from firms charging significant fees nonetheless.