Beware of Crashing Hedge Funds

I read a while back that superinvestor Warren Buffett made a big, bold bet: Hedge funds will underperform the S&P 500 over the coming decade. Why would Buffett bet against such massively popular investment vehicles, which controlled nearly $2 trillion in recent years, according to estimates? As it turns out, they're not as ideal as their hot reputation might suggest.

For one thing, hedge fund managers frequently take around 20% of all fund profits for themselves, atop the 1% to 2% they charge investors in annual fees. If the fund earns outsized returns, it's easy to rationalize such gargantuan paydays. But if the fund tanks, investors face serious pain.

In addition, hedge fund managers enjoy fewer restrictions than mutual fund managers or ordinary investors, so they can and do take greater risks. Hedge funds frequently invest in options and futures, sell stocks short, buy on margin (using borrowed money), and make bets on currency fluctuations.

Trouble in paradise
Such devil-may-care tactics often lead funds to take on way too much debt in their pursuit of big returns. If the market tanks, as it has recently, overleveraged fund managers could find themselves owing more than their holdings are actually worth! And if investors start to worry about a fund's recent or future performance, they'll often start withdrawing billions of dollars, just as managers need that money most.

Indeed, massive activity from hedge funds may help explain the market's recent jitters; economic strategist Ed Yardeni referred to hedge funds' recent selling as "the greatest margin call of all time." Faced with massive losses and bleak consumer confidence, many hedge funds will have to shut down completely.

At his Freakonomics.com blog, Steven Levitt argued that things may get even worse. Lock-up restrictions prohibit hedge fund investors from withdrawing money for a certain time period after they invest it. If some investors have been eager to pull out their funds, but aren't yet able to do so, recent withdrawals may be the tip of the iceberg.

The good -- and bad -- news
Fortunately, most of us won't experience major losses from our hedge-fund investments -- mostly because we don't have any. Hedge funds are typically only open to "accredited investors," folks earning upward of $200,000 per year or worth more than $1 million. (Regulators are considering raising these minimums.) These wealthy individuals typically invest $1 million or more at a time.

Still, if many hedge funds implode, along the way they'll be selling off the stocks they've been holding. That selling will depress those stocks' prices; if we hold those stocks, our investments will suffer, too.

According to Goldman Sachs, which tracks hedge fund holdings, major hedge fund holdings include the following companies:

Source: Goldman Sachs, Yahoo! Finance.
* Since emerging from bankruptcy on Jan. 10, 2008.

What can we do?
If you're thinking about investing in hedge funds, think twice. True, some are better-managed than others, and they may continue to do well. Before you sign up for any hedge or mutual fund, make sure you know your manager; the market's recent moves make level-headed leadership more important than ever.

Still, given a choice between hot-to-trot hedge funds and old reliable mutual funds, I'd rather put my money in the latter. Mutual funds are more regulated and more restricted, and while they can't match hedge funds' stratospheric potential returns, they're also unable to take on massive debt or dabble in certain risky investments. That security should help you sleep better at night -- which is more than we can say for many hedge fund managers these days.