On Hedge Funds—The Good and the Bad

As an investment adviser who has spent considerable time looking at alternative investments, I found the article, “Freedom from Market Swings” ( JofA, May02, page 49), somewhat simplistic and potentially misleading to readers. Although I agree there may be merit to investing in alternatives to provide diversification from “long-only” equity investing, some alternatives can be a treacherous investment arena.

The article states that most hedge funds are “run by experienced managers whose goal is to minimize risk.” In fact, the challenge in alternative investing today is finding experienced and capable managers who still are taking money.

The article refers to hedge funds as offering “steady gains and wealth preservation, year in and year out.” There are many varieties of hedge funds. Many are extremely aggressive and can lose a lot of money in any given year. Others are conservative and can be thought of as bond equivalents. None of them would dare claim to make steady gains, year after year.

Some aggressive long/short managers are not trying to minimize risk at all. They’re simply trying to make as much money as possible because they’re paid on an incentive basis. With these types of hedge funds, it’s critical to learn how much of the manager’s own net worth is invested in a fund.

I agree that a fund-of-funds approach makes the most sense for the average investor. However, I believe there are more bad hedge fund managers than good ones and more average funds-of-funds than good ones. In addition, since most advisers now are touting “alternatives” and seemingly every brokerage firm under the sun is creating an “alternative” fund-of-funds, it appears to me that this sector will be the next area of investor disappointments and blowups.

Finally, it’s important to remember that the stock market generally has an upwards bias, whereas hedge fund performance is totally dependent upon the skill of the manager.

Robert Stenson
Larkspur, California